Yesterday, we analyzed ways to determine our tolerance for risk in our investment portfolios. That risk tolerance was based on when we needed the money, other income sources available, and our personal feelings and sensibilities regarding risk.
We also determined that there are three basic types of investors:
- Aggressive – long time horizon, multiple sources of income, willing to take risks
- Moderate – medium length time horizon, investing is a significant source of income, only somewhat risk averse
- Conservative – short time horizon, investments are the only source of income, very risk averse
Set up an investment account with only $500 at Scottrade
What would these three portfolios look like?
I’ve arranged these into a table:
| Investment Class | Aggressive | Moderate | Conservative |
| Cash & Equivalents | 0% | 15% | 20% |
| Bond Index | 10% | 25% | 40% |
| US Stock Index | 50% | 40% | 30% |
| International Stock Index | 25% | 15% | 10% |
| REIT Index | 10% | 5% | 0% |
| Precious Metals Fund | 5% | 0% | 0% |
Cash (and its equivalents) are the safest of all investments. It’s basically like having money in a savings account
Bonds are like shock absorbers for your portfolio. They absorb a lot of volatility and keep your investments on the road.
The US Stock Index is one of your higher returning investments and it obviously has a good bit of volatility. Make sure it has more than 500 stocks in it. Many times the top 500 will be suffering while the next 1,000 companies are doing quite well.
The International Stock Index allows you to capture some returns from emerging overseas markets and makes your portfolio well rounded.
The REIT Index is an index of real estate investment trusts. It has some pretty significant risk but the potential for some very good returns.
The Precious Metals Fund is your most risky investment class. I recommend that only the most aggressive investors utilize this fund’s outstanding returns because only they can also handle the spectacular volatility and risk.
A Sample Aggressive Portfolio
A Sample Moderate Portfolio
A Sample Conservative Portfolio
Diversification
Your next step in building an investment portfolio is to decide how to diversify your portfolio within each asset class. ETFs are a great way to do just that. By investing in an index ETF, you’ll be able to get the benefits of diversification without having to keep up with dozens of investments. The diversification choices you make should depend on your risk tolerance and on the expense ratio of the particular ETF or other investment.
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{ 1 comment }
Asset Allocation is the most important determinant of investment returns. Your emphasis on asset allocation is the right way to teach people the basics of successful investing. But I would have to beg to differ with you on your characterization of a “conservative portfolio”.
After 30 years of falling interest rates and rising bond prices that now have yields at near record lows; Bonds are not the conservative asset they have typically been in past decades. The risk of long term bonds (the only place on the yield curve to make any money) is very high and probably not worth the risk.
Valuation matters! Investors need to consider valuation in their asset allocation mix. Due to the laws of compounding, sometimes it’s more important to not lose money than it is to try use a fixed asset allocation. A tactical asset allocation would allow for taking valuation into consideration when choosing an asset allocation mix.
Ken Faulkenberry