The ideal portfolio
Investors of all stripes spend a lot of time worrying about the ideal portfolio. Financial magazines covers (“7 Best Mutual Funds”, “8 Stocks to Buy Now”) beat out fitness and glamour magazines when it comes to airbrushed deception. Others look for the hot stock tip that will pull a Cisco. (The unprecidented growth, not the unprecidented decline.) Still others worry about the right mix of assets: 12% or 15% REITs? Should I favor small/value stocks? What type of bonds should I own?
A sensible person would tell you that there is no ideal portfolio, no secrets, and no silver bullet. That there are better and worse portfolios, and better and worse investments, but chasing perfection is silly. That ideals often collide - simplicity vs. optimization, market-tilt vs. value-tilt, ETFs vs. mutual funds, frequent vs. annual rebalancing. That the ideal is only known after the fact and can’t be predicted, even with the help of backtesting. That you should work out a good plan and stick with it, rather than seeking the idea.
Forget that. There is a perfect portfolio. It is the one where you keep investing lots of new money regularly.
Of course, your underlying asset allocation should be reasonable for this to be the ideal portfolio. A simple lazy portfolio will do fine, like the 3-fund Margarita portfolio (1/3 US Total Stock Market, 1/3 International Total Stock Market, 1/3 TIPS) or David Swensen’s 6-fund portfolio (30% US TSM, 15% Developed International Stocks, 5% Emerging Market Stocks, 20% Real Estate, 15% TIPS, 15% Treasury Bonds).
But choosing between these portfolios, or fine-tuning your asset allocation, is less important than saving.
Let’s take an example. You have a small nest egg of $20,000 at the age of 30. You invest it and manage a respectable 10% returns for 30 years. You spend exactly what you make for the rest of your life - no debt, but no savings either. What do you end up with? $340,000. Adjusted for inflation, this is maybe $150,000 in today’s dollars. You’re in trouble, despite the miracle of compound interest.
Now imagine that you save regularly, to the tune of 10% of your annual income. If your income is $50,000, you now have over $1.2M. Double that, and you have $2.1M.
This is far more than the $340,000 in the previous scenario. But more importantly, you can control this part - if the market only returns 8%, or 6%, your additional savings are still there, and become an even more important part of your portfolio.
Compound interest is powerful, and higher returns can make a big difference over time. But the “ideal” asset allocation can’t be known ahead of time. What you can know is the benefit of every additional dollar that you put away.
