Creating a portfolio

Before you even go looking for the ETF or ETFs to buy, you need to have the portfolio you want to build clearly set out in your mind. In constructing your portfolio, there are a few points that you need to be clear on, and I will explain these below.

1. Risk-Return Ratio. In my life, I have received the question, " how much do you earn with trading?" at least one hundred times. And the same question comes from those who wanted to invest, the first concern for them is how much they could earn. No one ever asked me about the losses or the risks I or them may face. The truth is that return and risk, gain and loss, are two sides of the same coin. If you are aiming for a bigger gain, then you are also taking a bigger risk.

Let me give you an example. Investing in a long-term US (treasury) bond ETF gives about a 2.5% return per year, investing in an HY (High Yield) bond ETF gives more than double that return, about 5.7%. The question is, which one would you invest in?

If you answered the second, your answer is wrong. If, on the other hand, you answered the first, the answer is... wrong. How can you decide to invest in something without knowing the risk you are going up against? Obviously, there is a reason why the two ETFs give such different annual returns. The first one is lower but has on its side the fact that it is composed of treasury bonds, so it has a high rating. In practice, losing your money would mean putting the U.S. in default, which is very unlikely (at least at the time I'm writing).

The second is composed of bonds issued by companies (mostly American), some of which have a low rating (defined as "junk") and are therefore decidedly less secure than treasury bonds. It is obvious that if a bond has a yield of 13% per year, it means that the company that issued it has a bad rating and there is the possibility that at maturity it will not be able to honour the debt.

So, the answer to the question is, "it depends on your investment priorities and the risk you are willing to take".

2. Efficiency. A key point is that you need to build your portfolio in the same way that a tailor would make your suit. It has to be tailored to you, to your investment idea, to your risk appetite, to your financial goal, to the duration you have envisioned. Only then can it be an efficient portfolio.

Don't think for a moment about asking me or anyone else to build you a portfolio to invest in. I would tailor it to me which would almost certainly not coincide with your investment idea. That would only bring you to worry and sleepless nights. And even if you do make a profit in the end, it can hardly be said that that portfolio is efficient for you.

Don't you find it at least a bit bizarre that this stressful approach means getting what you want to improve your quality of life but at the expense of making your quality of life worse?

So, follow the dictates of your investment idea and build your own portfolio. Only then can it be called efficient.

3. Diversify. This is a key concept when building a portfolio and it's a bit more complex than you've seen it so far. When you buy an ETF, you diversify your investment across multiple stocks or bonds. This is all fine and good, but diversification needs to happen at the portfolio level as well.

You must invest in several markets (equities, bonds, commodities...) which are not correlated with each other in such a way that the fall in one ETF is at least partly covered by the rise in another ETF. Two markets are correlated if a rise in one corresponds to a rise in the other and vice versa, a fall in one corresponds to a fall in the other. The two markets are not correlated if this relationship is broken.

Diversification is not something that increases the performance of your portfolio but decreases the risk.

An example can be found in so-called safe-haven assets. In periods of sharp declines in stock markets, it happens that large investors (funds) exit the stock market and invest in safe-haven assets, considered safer, especially gold. If you go and see, in 2008 in the face of a sharp fall in equity markets following the bankruptcy of Lehman Brothers, gold closed the year with a positive performance. It would not have been enough to cover the entire loss suffered by the stock market but nevertheless, it would have diminished its magnitude. The same happened in 2020.

A simple portfolio diversification is as follows:

• 25% monetary (i.e., short-term bonds, maximum three years);
• 25% long-term bond (10 years or more);
• 25% stock;
• 25% gold.

This way, you have a fairly balanced portfolio with low risks. Monetary and bonds do not only bring home a return but also lower the volatility of the portfolio. Equities are the riskiest part and the one that contributes the most to the performance of the portfolio. Gold mainly serves as a hedge.

Percentages can be changed depending on the historical period. If you are living in a profitable period for the stock, you can increase the exposure to the detriment of gold for example. In periods of uncertainty, you can do the exact opposite, decreasing the stock and increasing the other three.

Always keep in mind that choosing the markets you invest in and their percentages is what will determine the performance of your portfolio. You need to weigh the markets you invest in well, based on your financial objective.

4. Balancing. After seeing how you can diversify a portfolio the next step is balancing it. Unfortunately, this is easier said than done because you have to use your calculator. I'll explain it with an example, trying to make it as simple as possible on the numerical level.

You want to invest $ 100,000, divided into four equal parts (25%) for each asset just as seen above. So, $ 25,000 in cash, $ 25,000 in bonds, $ 25,000 in stocks and $ 25,000 in gold. All ETFs were purchased to provide for the accumulation of dividends/returns.

After one year, the monetary gained 2%, the bond gained 5%, the stock gained 22% and the ETC on gold lost 5%. Now the percentages into which the investment is divided are no longer all 25% but:

• monetary ($ 25,500) 24.06%.
• bond ($ 26,250) 24.76%.
• stocks ($ 30,500) 28.77%.
• gold ($ 23,750) 22.41

Therefore, the percentages have to be rebalanced to return to 25% again. First, you have to sum the value of all assets ($ 106,000) and divide by the number of assets (4): the result is $ 26,500. Then from the stock (the only asset of higher value), you have to disinvest $ 4,000 ($ 30,500 - $ 26,500 = $ 4,000) and distribute this money proportionally in the other assets.

So:

• monetary $ 1,000 ($ 25,500 + $ 1,000 = $ 26,500)
• bond $ 250 ($ 26,250 + $ 250 = $ 26,500)
• stocks $ 30,500 - $ 4,000 = $ 26,500
• gold $ 2,750 ($ 23,750 + $ 2,750 = $ 26,500)

The money you invested in cash, bonds and gold ($ 1,000 + $ 250 + $ 2,750 = $ 4,000) is exactly how much you disinvested from equities. Again, this is all very easy to say, but not so easy to do in practice, because you can't always disinvest and reinvest exactly what you have calculated. But you do have to try and get as close as possible.

The rebalancing can be done annually or semi-annually (I do not recommend shorter periods due to the costs involved in selling and buying ETFs). The same ETFs are regularly rebalanced by the issuing companies so that each stock or bond always maintains the same weight within the basket.

It is important, therefore, that you rebalance your portfolio from time to time because this will ensure it will always be well-diversified according to your investment idea and the financial objective you are pursuing. Otherwise, you will be more on one asset and less on others, changing the overall risk of the investment (and making the portfolio less efficient).