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Summary Standard portfolio development theory provides a great foundation. Unfortunately, the stock and bond markets don’t always cooperate. Take the approach of accepting what the markets offer to improve total return. Introduction There are literally dozens of articles and books written on the subject of portfolio development theory. Most of those articles and books approach the development of a portfolio using a mix of stocks and bonds with the mix dependent on the investors tolerance for risk and the investor’s age. I think that this “standard” approach to portfolio development is great if you have the luxury of time to build that portfolio over a number of years and business cycles. Without the luxury of time, I don’t believe the “standard” approach works all that well. Making things even more difficult, today we have a unique investment environment. Yes, it really is different this time. We are currently in a period of ultra low interest rates with the most likely course going forward being slowly rising rates. Bonds may not return much over the next few years and if the economy and inflation accelerate, total return could be negative. What is an investor to do? My approach is to accept what the market has to offer. Standard Portfolio Development As stated in the introduction, there is a lot of information available on portfolio development theory. It is not my intent to provide a detailed discussion on the subject of standard portfolio development. I will summarize what I consider to be the standard approach in this section and refer the reader to articles available on the internet if more detail on the standard approach is desired. Most portfolio development starts with identifying the investor’s tolerance for risk. Because the risk of having poor or even negative returns can be mitigated with time invested, an investors risk tolerance also has an age component. Younger investors can generally tolerate more risk because they have many years to invest and accumulate wealth. To see the market behavior over various time periods, you could look at available charts . Another option is to use a market return calculator to look at various time periods. While you might be able to find a 30 year period with a slightly lower return if you work at it, the stock market has returned 8% – 9% average per year for any 30 year period since 1900. The bottom line is that time in the market lowers your risk of having a poor return provided you have a reasonably diversified portfolio of stocks. The standard portfolio model also uses diversification between asset classes to mitigate risk. Assets are typically divided primarily between stocks and bonds with a cash account outside the portfolio sufficient to cover 3 – 6 months of living expenses or for other emergencies. The rationale behind splitting the main portfolio between stocks and bonds is that the two asset classes typically complement each other. If equities have a terrible year, the investor should still receive a positive return from their bond holdings. One long standing rule of thumb for the split between stocks and bonds is to use 120 minus the investors age as the percentage for equities in the portfolio. As an investor ages, the portfolio percentage dedicated to stocks drops. The table below illustrates the portfolio stock percentage as a function of age. While this is a decent rule of thumb to follow, there is no universally agreed split between stocks and bonds and some recent thinking is that the typical split between stocks and bonds as a function of the age of the investor may need to weight more heavily stocks versus bonds. The reason for this shift to a relatively higher asset allocation to stocks is because we have had a long bull market in bonds and current yields are extraordinarily low. This makes it less likely that bonds will provide adequate returns going forward at least relative to historical returns. Stocks and bonds should also be diversified within the respective asset class. Depending on the value of the portfolio, it may not be practical for an individual investor to achieve the level of diversification necessary to adequately mitigate risk. Diversification in stocks is easier to achieve because stocks can typically be purchased in small increments. This is not the case with individual bonds. As an example, a round lot for a stock investment is 100 shares and the cost penalty for an odd lot (Scalper1 News
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