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 in your mind. When constructing your portfolio, there are a few points you need to be clear on, and I will explain them below.

1. Risk-return ratio. In my life, I have been asked “How much do you earn with trading?” at least a hundred times. The same question comes from those who want to invest: their first concern is how much they could earn. No one has ever asked me about the losses or the risks that I or they 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, while 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 facing? Obviously, there is a reason why the two ETFs give such different annual returns. The first one pays less but has in its favour that it is composed of US Treasury bonds, which have a high rating. In practice, you would lose your money through a default only if the US went into default, which is very unlikely (at least at the time I’m writing). However, as you have seen, the price of long-term bonds can fall considerably when interest rates rise.

   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 safe 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 its 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 your time horizon. Only then can it be an efficient portfolio.

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

   Don’t you find it at least a bit bizarre that this stressful approach aims to improve your quality of life but ends up making it 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 what you have seen 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, …) that are not correlated with each other, so that the fall in one ETF is at least partly offset by the rise in another. 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 does not increase the performance of your portfolio; it reduces the risk.

   An example can be found in so-called safe-haven assets. In periods of sharp declines in stock markets, large investors (funds) tend to leave the stock market and move into safe-haven assets, considered safer, especially gold. If you look at 2008, after the 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 it would nevertheless have reduced its size. The same happened in 2020.

   A simple way to diversify a portfolio is as follows:

   • 25% monetary (i.e., short-term bonds, usually 12 months or less);
   • 25% long-term bonds (10 years or more);
   • 25% stocks;
   • 25% gold.

   This way, you have a fairly balanced portfolio with moderate risk. Monetary and bonds not only bring 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 through a favourable period for stocks, you can increase your exposure to them at the expense of gold, for example. In periods of uncertainty, you can do the exact opposite, decreasing stocks 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 a calculator. I’ll explain it with an example, trying to make it as simple as possible numerically.

   You want to invest $100,000, divided into four equal parts (25% for each asset) as seen above. So, $25,000 in monetary, $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 ETF gained 2%, the bond ETF gained 5%, the stock ETF gained 22% and the gold ETC lost 5%. Now the percentages into which the investment is divided are no longer all 25% but:

   • monetary ($25,500): 24.06%
   • bonds ($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 add up the value of all assets ($106,000) and divide by the number of assets (4): the result is $26,500. Then, from the stock ETF (the only asset worth more than that), you have to disinvest $4,000 ($30,500 − $26,500 = $4,000) and distribute this money among the other assets so that each reaches $26,500.

   So:

   • monetary: $1,000 ($25,500 + $1,000 = $26,500)
   • bonds: $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 added to monetary, bonds and gold ($1,000 + $250 + $2,750 = $4,000) is exactly the amount 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 should try to 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 ETFs themselves are periodically rebalanced by the issuers so that each stock or bond keeps the weight it has in the benchmark.

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