Retirement investors often hear that they should build a portfolio, rather than picking stocks based on tips and gut feelings. Easy to say and, for a long time, it was hard to do.
Pension funds and universities really understand portfolio building, as do many wealthy individuals. For all the blather you hear on TV about which stock or sector a famous-name investor supposedly will buy next, the fact is rich people do not often take all-in risks.
Rather, they keep their money in a variety of asset classes. The rich also regularly rebalance — they sell the investments that have gone up and use that cash to buy those that have fallen — and they own more conservative investments than you might guess.
How can you build a strong retirement portfolio? Here are the basic principles:
A “three buckets” approach
A cash cushion of three to six months expenses is crucial. It helps you avoid selling to raise money for, say, a hospital visit or a car accident. The second bucket is your retirement investments. It should be the largest component and handled as inexpensively and consistently as possible. This is your ‘”core” portfolio.
The third, if you are disposed to trading, is the “explore” bucket, money you don’t mind losing if a stock doesn’t work out. You don’t have to trade. If you know you will, however, keeping that money separate from the core portfolio protects you from emotional trading errors.
Avoid unnecessary costs
Inside the core portfolio, it’s vitally important to keep costs minimized. Own index funds or index ETFs rather than expensive, actively managed mutual funds. You can easily lower management costs, taxes and commissions by owning ETFs inside an individual retirement account (IRA).
Costs matter. John Bogle, the founder of the Vanguard Group, figures management fees over the long haul eat up to 80% of your potential gains. Fund managers and other Wall Street types put up nothing and risk nothing but keep 80 cents on your dollar. It’s shocking once you realize it.
Diversification is a virtue
When you first start using truly diversified investments the feeling can be deflating. Why invest if you don’t get to pick the companies?
The answer is simple enough: You will pick the wrong ones. Most people chase investments that have been hot recently, buying them just in time for a decline. Once they buy the high, they ride it down to the low and then cash out. Yet, many times, a down stock soon recovers.
Diversification lowers this risk by cutting off your emotional attachment to a single company or sector. It protects you from yourself.
Ordinary retirement investors can and should build their own investment portfolios, and they can do so cheaply using the same, proven portfolio tools afforded even the fanciest university endowments.