If you have ever done any home remodeling, you know that painting a room involves more than just picking a color and brushing on the paint. Similarly, setting up a portfolio involves more than just picking investments and placing trade orders. As with properly painting a room, personal portfolio management requires some important pre-work first.
Here are the analogous "prepare the walls and tape the molding" steps when setting up a portfolio.
How much money do you have to invest?
Before investing in long-term accounts, check to see that you have set up adequate cash reserves. Similarly, if you have onerous or expensive personal debt, the best use of available cash might be accelerated payments on that debt. (Paying down debt offers you the same return as making an investment that offers an immediate risk-free return about equal to the interest rate you are being charged on the debt.) Also, do you have appropriate insurance in place, i.e. enough financial protection in the event of a death or disability in the family?
These considerations may not be any more interesting to you than "preparing the walls and taping the molding", but they are the first step in setting up a strong personal portfolio.
What is the goal of the portfolio?
Just as you need to understand how a room will be used in order to pick the appropriate paint color, understanding the goal of the portfolio helps you to set the right level of risk. Risk is goal dependent. For individual investors, everything else being equal, the more highly valued a goal, the less risk you'll want to take in the supporting investments.
For example, as you prepare for retirement, there is likely some standard of living below which you do not want to go as you age. If so, then your retirement portfolio will reflect a “safety-first” approach; in retirement, you would first arrange lifetime, inflation protected income sufficient to cover that base standard of living before exposing other retirement wealth, for example, to stock market risk. This part of your portfolio might be the room with "calm colors".
What is your risk capacity?
When picking a room color, it makes sense to consider how that room fits in with the rest of the house. Similarly, when picking an investment strategy, it makes sense to consider how the rest of your financial life might influence the risk you take in your portfolio.
For example, if paying for college is a very highly valued family goal, and if there is no other wealth beyond the college savings portfolio to pay tuition bills, then you won't want to take much investment risk with the college savings. There is no Plan B funding for this highly valued goal.
On the other hand, if you have other wealth—either portfolio wealth and/or the ability to draw on earned income for tuition bills—then you might be able to set a higher risk level for the college savings portfolio, if you choose.
If a portfolio fails to perform as planned, what would you do? The less resilience in your answer, the less risk you'll want to take in the portfolio.
What is your risk tolerance?
Risk tolerance is also an important portfolio planning consideration. You might really enjoy a high level of risk in your career, e.g. perhaps you are a real estate developer or an entrepreneur, or you might love extreme (risky) sports. That doesn't necessarily mean that you also enjoy volatility in your investments. Similarly, you may have very ample wealth relative to your chosen lifestyle, and despite having very ample risk capacity, you may not enjoy owning anything that you perceive as risky.
In the world of home decorating, there might be a "perfect" appropriate color suggested to you for the room you are considering painting, but if you can't live with that color, it doesn't matter if the suggested color fits perfectly with the rest of the house. It won't work for you. The same goes for investment risk.
What are appropriate portfolio expenses?
When redecorating a home, it matters if your paint store offers honest, expert services at a reasonable price and if the paint you ultimately purchase is of high quality and also reasonably priced. In the investment world, if you are starting a portfolio from scratch, you'll want to pick a brokerage firm to house the portfolio that offers the combination of services and fees that work for you and investment vehicles that are competitively priced.
If you are switching to a new portfolio strategy, careful attention to transition expenses is warranted. For example, will there be exit fees if you liquidate former investment holdings? What will be the tax impact? Would it make sense to pair investment strategy with charitable intent by using a donor advised trust, or with family gift strategies (e.g. by transferring low basis assets to low tax bracket family members)? Tax expense can also be minimized by using tax-exempt and tax-managed vehicles in the taxable portfolio and placing tax-inefficient investments in the tax-sheltered retirement accounts.
Prudent investors also consider carefully with whom they do business. The careful choice of brokerage firms, fund companies, and other counter-parties for your family's finances helps minimize the possible cost of doing business with a "bad player" in the financial industry.
What are good investment vehicles?
Like paint colors, investments are neither “bad” nor “good”. What matters is how they fit in with the portfolio as a whole and if there has been adequate attention to tax and other costs. In previous blog posts, we've made the case for international diversification and for the use of low-cost index fund strategies. For this post, suffice it to say that crafting a tax-sensitive diversified portfolio with the appropriate level of both cost and risk is for sure a foundational step in personal portfolio management.
Once an appropriate portfolio strategy is chosen and implemented, it can be very gratifying to then stand back and admire the finished product, much as you might stand back and admire a freshly painted room in your home.
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