How to build a portfolio that balances boring yet safe with exciting but riskier investments

Welcome to the latest post in my journey to build financial literacy for young adults. As mentioned in my previous post, the next few topics are going to be on some basics of investing, with today’s focused on how to balance risk and potential return when building a portfolio.

While it’s a necessary and critical part of managing one’s finances, investing doesn’t need to be just “boring and painful” as my children often tell me. One can design a portfolio which is aimed at building long-term wealth (the boring part of investing) while also leaving space for exciting, high-risk and potentially high-reward investments. As I’ve consistently shared starting with my first post (https://vocal.media/trader/why-and-how-to-save), today’s young adults are very focused on those latter items – the lucky, homerun investments of the moment where people have become millionaires overnight from their cryptocurrency or Tesla options trades. Although those are very exciting examples, very few people actually end up hitting those homeruns whereas a lot more of them lose money by chasing get-rich-quickly schemes. The boring but true reality is that most successful portfolios grow slowly over time through the magic of compounding.

My preferred approach for building a portfolio is to use the 80/20 rule, which is based off the Pareto principle that you have likely learned about at school (https://en.wikipedia.org/wiki/Pareto_principle):

Start with 80% in safer “core” investments: This is the heart of your portfolio which you are counting on to provide a good but safer return to your overall finances. This part of your portfolio should be balanced and provide diversification by investing:

• Across asset classes: stocks, bonds, real estate, cash

• In diversified vehicles such as mutual funds

▪ There are many investments in each fund which minimizes the negative impact of a single investment going sour. However, this also means that you trade off the potential of a single, homerun investment to significantly increase your returns

▪ Ideally a passive investment such as an index fund. Many years of results and multiple studies show that passive funds outperform actively-managed funds*, in particular due to their low costs

Round it out with 20% riskier but potentially higher return investments. This is the “exciting” part of investing where there is the potential for a large return which can be the homeruns to really supersize your returns. However, there is also a larger risk of losing most or all of this money. These include:

• Individual stocks or bonds which have idiosyncratic risk
• Rental properties or other large, single real estate investments
• Futures and options
• Investments made with leverage (borrowed money)
• New asset classes such as cryptocurrency or NFTs

Please note: the 80/20 breakout is a rule of thumb. The actual breakout for your portfolio should depend on your circumstances. Generally, the 80% will be higher if a person:

• Is in riskier circumstances: If they have low job security or have high ongoing financial commitments, they have less ability to absorb a financial loss
• Is more risk averse: Investments run across a gamut of risk. Most investments will sees decreases in their value at some point with riskier ones likely to see greater decreases. If you are apt to sell your investments when you see a small fall in their value, reduce the amount of your riskier investments
• Has less experience in investing
• Has a smaller portfolio: The impact of losing a given amount of money will have a bigger impact on your long-term financial welfare
• Is closer in time to covering a big expense which the investments are intended to cover (i.e., buying a house or entering into retirement)

Having a mix of investments gives you the opportunity to slowly grow your wealth and maintain good financial shape through the safer, core portion while also still offering the exciting potential to supercharge your portfolio with higher returns through the riskier investments.

Hope you find the guidelines I use in building out a portfolio to be useful as you think about your investments. Thank you again for joining me on my journey to build financial literacy for young adults. If there are any topics you’re interested in my writing about, please let me know. I can be reached at [email protected].

* More evidence that passive fund management beats active, Marketwatch, 9/16/2019; https://www.marketwatch.com/story/more-evidence-that-passive-fund-management-beats-active-2019-09-12

** Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors, BRAD M. BARBER and TERRANCE ODEAN, The Journal of Finance, April 2000 (https://faculty.haas.berkeley.edu/odean/papers%20current%20versions/individual_investor_performance_final.pdf)