What is a ‘Balanced’ Portfolio?

A balanced portfolio is like a balanced meal, it has lots of diversity and will leave you feeling satisfied. Let’s build a balanced meal together, shall we?

There are thousands upon thousands of things to invest in. There are stocks, bonds, real estate investment trusts (REITs), NFTs, cryptocurrency, and many more things you can invest (or gamble) your money into. It can be intimidating trying to figure out what to invest in, and in what quantities.

Although there are many investment options out there, you can build a balanced and high-performing investment portfolio prepared to weather the storms with only three asset classes: stocks, bonds, and cash.

Stocks should make up the core of your portfolio, serving as your primary wealth-builder and your hedge against inflation. Bonds serve as a more stable and conservative investment option and help protect you from deflation (a decrease in the value of goods and services). Cash is your most steady and flexible option, used to pay your living expenses in retirement, as your emergency fund, and to potentially complement a more aggressive stock-based portfolio.

If you need a refresher on what stocks and bonds are, alongside some killer comparisons to breakfast foods, refer to this newsletter from Wilson.

Building a balanced portfolio is all about diversification. Diversification is simply investing across various assets, industries, and other categories so all of your eggs aren’t in one basket. Generally speaking, the more things you invest in, the lower your overall risk and reward. And vice versa.

Crafting a balanced investment portfolio is a two-step process:

1. Choose what you’ll invest in

2. Determine your asset allocation

1. Choose what you’ll invest in

Those who invest all of their money in a single stock are like those who follow the carnivore diet; they’re definitely insane and probably have tapeworms. If you invest 100% of your money in Tesla stock, you’re putting their entire investment portfolio in the hands of Elon Musk, the man who named his kids X Æ A-12, Exa Dark Sideræl, and Techno Mechanicus, among others. If Tesla stock goes to the moon, your money will go to the moon with it. If Elon’s shenanigan of the week evokes the destruction of Tesla, your money would vanish with it. High risk, high reward.

On the other side of the crazy fence is investing all of your money in a single bond. This is like a diet consisting only of tapioca pudding, it’s boring and sure to disappoint. Low risk, low reward.

If you’ve followed this newsletter for any amount of time, you probably know my stance on investing in individual stocks and bonds. If not, TLDR: I don’t like ‘em. Instead of picking random individual stocks and bonds and hoping you end up with a balanced portfolio, investing in index funds, ETFs, and bond funds is a better option.

Bond funds are the bond equivalent of index funds. Like a US total stock market index fund, total bond funds consist of a collection of numerous bond types in varying quantities. Most major brokerages offer total bond funds to investors, often tracking the Bloomberg Barclays US Aggregate Bond Index or a similar bond index.

Here are four examples of simple investment portfolios with varying degrees of diversity, growth potential, and volatility:

1. Total US stock market index fund OR S&P 500 index fund only (no bonds)

This is a high risk portfolio with 100% stock allocation. There is also no international fund which means you’re only investing in US Companies.

2. Total US stock market index fund OR S&P 500 index fund + Total international index fund/ETF (no bonds)

This is also a high risk portfolio with 100% stock allocation. This option includes an international fund which increases your diversity.

3. Total US stock market index fund OR S&P 500 index fund/ETF + Total international index fund + Total bond fund

This option is the most diverse with US, international, and bonds.

4. Total US stock market index fund OR S&P 500 index fund + Total bond fund

This option takes out international companies.

Your selection between a total US stock market index fund and S&P 500 index fund doesn’t really matter, since there’s a lot of overlap. Bottom line: If you want to invest in a broader pool of US companies, choose the total stock market index fund. If you want exclusive exposure to large-cap US companies, choose the S&P 500 index fund.

The decision whether or not to invest in international stocks is a polarizing one.

On one side, including international stock exposure in your investment portfolio increases the overall diversification of your portfolio and counters US/recency bias. Although US stocks have outperformed international stocks in recent history, this hasn’t always been the case.

Reasons why not to invest in international stocks include the significant overlap between US and international stocks, the correlation between the two markets, and the introduction of currency risk into your portfolio.

Personally, I keep a small (~5%) international stock holding to maintain some exposure to international markets.

Here’s a snapshot comparing the focus, diversification, and volatility of the four investment portfolios listed above. The numbers in the picture correspond to the numbers on the list above.

2. Determine your asset allocation

Once you’ve decided what portfolio you want to invest in, the next step is to select your asset allocation. That is, the percentage of your portfolio you’ll invest in a US index fund, international index fund, and/or bond fund. Your asset allocation should be viewed in two distinct stages: the wealth accumulation stage and wealth preservation stage.

The wealth accumulation stage is when you're still earning an income through your job and actively saving for retirement. Your asset allocation should be oriented toward the growth needed to reach financial independence in your desired timeframe. Since you still have an income during this stage, you can afford a more aggressive index fund allocation.

The wealth preservation stage is when you're living either entirely or partially on your retirement savings and other forms of passive income, such as rental income or Social Security. Your asset allocation should be structured to best sustain your portfolio from the day you retire to the day you croak. Introducing bonds to your portfolio can help smooth out the ride for your money, better protecting your portfolio against significant market downturns early in your retirement. The lower your withdrawal rate in retirement, the more bonds you can hold without running out of money. However, keeping too much of your portfolio in bonds can hinder the growth you may need to sustain a longer retirement.

It’s all a balancing act. In either stage, I recommend keeping no less than 50% of your investment portfolio in index funds.

To recap, consider the following factors when determining your asset allocation.

Need for growth: The more growth you want from your investment portfolio, the higher percentage of stocks and lower percentage of bonds you’ll need.

Risk tolerance: The higher your risk tolerance, the more stocks you can afford to hold without being spooked into pulling all your money out of the market if it declines.

Investment horizon: The more time you have to invest before you plan to retire, the higher percentage of stocks you should hold a) to drive more growth, and b) because your portfolio has more time to recover from any downturns.

Check out the table in this newsletter to see how different asset allocations perform over different lengths of time in retirement.

What about REITs? Real Estate Investment Trusts are companies that invest in income producing real estate. In order to be listed as a REIT, they have to pay at least 90% of taxable income to shareholders. They offer great dividends but little appreciation. We will go deeper on REITs in a different letter.

What about cryptocurrency, NFTs, individual stocks, etc.? I don’t invest in any of these, but if you want to shoot your shot, keep this total to 5% of your investment portfolio or less. Don’t invest more than you’re willing to lose.

Just like that, you’ve got a well-balanced investment portfolio ready to take on the world.

Call to Action

Determine what funds/ETFs you want to invest in, select your asset allocation based on the factors mentioned above, and start investing!

What We’re Reading/Listening To:

Think Again by Adam Grant. I’m only halfway into it, but I’m a fan so far. This book helps you reevaluate why you believe what you believe, helping you be a more critical thinker.

Debrief on Deck

Next week, Wilson will continue the discussion on when you should buy vs. rent a house, you won’t want to miss it.

As always, please reach out to us with any questions or comments you have. You can reply directly to this email or find us on social media (X (formerly Twitter) and Instagram).

Until then, stay the course.

Disclaimer