Building a Resilient Portfolio
Last week I responded to a question about financial security by introducing the idea of financial resilience. Just as emotional resilience enables us to respond to the challenges of life in a positive way, financial resilience helps us better handle financial setbacks. Financial resilience comes as we follow correct principles such as living within our means, avoiding unnecessary debt, and investing properly. Investing properly means building and maintaining resilient portfolios.
A resilient portfolio is like a seaworthy ship. Well-engineered and properly maintained, a seaworthy ship will safely carry cargo and passengers through good weather and bad. A resilient portfolio, likewise, is able to endure bad markets without a permanent loss of capital. With a resilient portfolio you can feel confident that your portfolio will not only survive a bad market, but that it will eventually recover and you will prosper.
Gaining this kind of confidence requires you to think about your investments in three interrelated dimensions: investment time horizon, asset allocation, and diversification. By systematically considering each dimension, you can build and manage a portfolio that will weather the market storms.
Your investment time horizon refers to how long the money will be invested. Different investment horizons come with different risks. For example, an investor with a horizon of ten years or more should worry about inflation. Even though the current annual inflation rate of 2 percent is barely noticeable year to year, it would still eat away nearly 22 percent of your portfolio’s value in the course of a decade. A long-term portfolio without adequate inflation protection is not resilient.
On the other hand, the market’s day-to-day price volatility may be a significant risk to the short-term investor, but it has very little bearing on the success or failure of a long-term portfolio. Taking time to understand your investment horizon and the risks associated with that horizon is the first step to building a resilient portfolio.
Once you have a clear understanding of your portfolio’s investment horizon, you can start thinking about your portfolio’s asset allocation. Asset allocation refers to how much of the portfolio you invest in different kinds of asset classes like stocks, bonds and cash and whether those investments are in the U.S. or in international markets. The right asset allocation for you depends on your personal situation and your portfolio’s investment horizon.
Portfolios with short horizons will invest more heavily in assets that are easily liquidated and maintain a stable value. Appropriate short-term asset classes include cash instruments like Treasury Bills, CDs, money market funds and short-term bonds. On the other hand, portfolios with longer horizons will usually invest more heavily in stocks. Long portfolios might also include allocations to various types of real estate, venture capital and private equity. These investments provide superior inflation protection and performance opportunities, but they can also be illiquid and volatile.
With your time horizon clear and your desired asset allocation defined, you are ready to put your money to work. Some people invest in individual stocks and bonds, but I prefer to use low-cost index funds. There are index funds for just about every major asset class. These funds provide a quick and inexpensive way to diversify your portfolio. By spreading your investments over a large number of individual companies, you can achieve your asset allocation and diversification goals. With index funds, you can have the peace of mind that comes from knowing that no single company is going to blow up and cause you irreparable harm. This assurance can give you staying power when the market is under pressure, helping you stay resilient until the market recovers.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.