Investment Portfolio

5 Key Factors To Building Your Investment Portfolio

A powerful way to have your money work for you is to build an investment portfolio. Then add to it consistently over time and let compounding take over.

Einstein referred to compounding interest as the 8th wonder of the world. If you can generate returns of 12% per annum, your wealth will double approximately every six years. 

Or, take this example. Let’s assume you start today with $15,000 in savings and I could show you a way of generating returns of 15% per annum. Here is how that would approximately compound:

  • Year 5: $30,000
  • Year 10: $60,000
  • Year 15: $120,000
  • Year 20: $240,000
  • Year 25: $480,000
  • Year 30: $960,000

By the end of year 30, your $15,000 investment portfolio would have grown to just shy of $1 million. Half of that capital generated in the last five years of the cycle. So, you should see how over time compounding turns into a wealth building machine!

Before you create your investment portfolio, though, there are a couple of things you need to know.

Psychological Barriers to Successful Investing

Herding behavior in investing

I'm still intrigued the market crash in 2008. Not by the economic ramifications, but by the role investors played in it.

Institutional wealth managers, financial advisors and seasoned analysts live and breathe the markets. Still, the events that unfolded in 2008 blindsided them.

The question I wanted to know was why, and the answers were quite simple.

They were overconfident in their ability to forecast future economic and market outcomes. They were also subject to the pressures of groupthink and guilty of adopting a herd mentality. Two forms of behavioral bias that threaten any portfolio once the trend in a market turns lower.

The Folly of Forecasting

CXO Advisory had been tracking and publishing "expert" forecasts of market direction since 1998. In their review carried out from 1998-2012 and including 6,459 forecasts, they concluded that the average experts accuracy in predicting the direction of the market was only 47%.

That’s right, less accurate on average than a random coin flip!

This outcome is important because it raises questions as to how you select securities to include in your investment portfolio.

The Herding Mentality

In the 1950s, Solomon Asch conducted a series of experiments called the Asch conformity experiments. Also referred to as the Asch Paradigm. The test illustrated the influence groups have on individual decision making.

Male college students participated in the simple perceptual task. But, in each test, all but one of the students was an actor. The questions was this. How would that one individual would respond following the answers of others in the group?

The results were startling.

In the environment without any actors present the error rate was less than 1%. In the experiment with the actors, the students answered 33% of the questions incorrectly.

Asch went on to perform similar tests in the following years. The results of which were all conclusive. As humans, we do indeed adopt a herd mentality.

The Pressure of Groupthink

In 1972, it was Irvin Jarvis that derived the term “groupthink”, which he described as the group process of making bad or irrational decisions.

Robert Shiller, Professor of Economics at Yale University, acknowledged a similar situation in the investment industry, in a 2008 New York Times article. In the article, Shiller described his struggles with groupthink and herd mentality, saying:

“While I warned about the bubbles I believed were developing in the stock and housing markets, I did so very gently and felt vulnerable expressing such quirky views. Deviating too far from consensus leaves one feeling potentially ostracized from the group, with the risk that one may be terminated.”

Makes you wonder. Are the financial experts contributing to rather than solving the problems of behavioral bias?

Unfortunately, I believe the answer to be yes in too many cases. Hence, the need for an independent system when creating your investment portfolio. A system focused on protecting and accelerating your wealth regardless of the economic climate.

A system based on proven indicators/ triggers and free from bias.

Asset Allocation Driving Investment Portfolio Returns

Several studies suggest asset allocation is the primary reason for differences in investment portfolio returns over time. Brinson Beebower and Hood (1986); Ibbotson and Kaplan (2000); Brinson, Singer and Beebower (1991) to name but a few.

One asset allocation strategy that has performed well is The Permanent Portfolio, devised by the late Harry Browne. The strategy based on an economic cycle comprising of four core categories:

  • Prosperity (i.e. Economic Growth)
  • Inflation
  • Deflation
  • Recession (i.e. Economic Decline)

Four asset classes, he determined, provide a means of boosting your investment portfolio returns during each of these four economic conditions.

The Permanent Portfolio
  1. Stocks: for profit during periods of general prosperity and/or declining inflation.
  2. Long Term Bonds: for profit during periods of declining interest rates (especially deflation). Bonds also do reasonably well during prosperity.
  3. Gold: for profit during periods of bad inflation.
  4. Cash: During a recession, no particular asset class is going to do well. The cash in a Treasury Money Market Fund offers stability when portfolio asset classes fall in price. It also protects purchasing power during a deflationary period.

Each asset class is held in equal weight (25%) and rebalanced at the end of every year in the investment portfolio. From 1972-2012, the compounded annual growth rate (CAGR) is 9.6%. That's in line with the Total Stock Market Index.

But, the Permanent Portfolio only produced losses in three of the years from 1972-2012. That compares with ten for the Total Market Index. Furthermore, the worst loss was far less. A mere 4.1% compared to a decline of 37% in the market.

A take on this investment portfolio is Ray Dalio's "All Weather" Strategy. Tony Robbins sells it as a revolutionary approach in his recent book. The reality is that the All Weather is quite like the Permanent Portfolio. My personal approach takes its inspiration from these two portfolios. But, there is some variation.

The Permanent Portfolio accounts for an inflation range (i.e. high or low). The All Weather Strategy covers the direction of inflation (i.e. rising or falling). So, why not combine both inflation and inflation expectations.

Furthermore, inflation should not be considered high or low only. It can also be stable. So too can inflation expectations.

So, I mapped this all out as a 3x3 matrix. Then, I added the asset class that best suits that economic climate. 

Brooks Asset Allocation Strategy

That's the starting point for construction of my investment portfolio.

Value & Trends Investing

On average, cheap stocks outperform expensive stocks. However, most investors need to be selective. That word average means little to them. In fact, value investors often get caught in value traps. That is, they invest in cheap stocks that continue to get cheaper.

In saying that, it is also true stocks with positive momentum tend to outperform those stuck in a negative trend. That is, winners keep winning while losers keep losing. The problem with investing in momentum stocks is it tends to be volatile. Trends can endure sharp reversals.

Most investors are not equipped mentally to handle such swings in the market.

The solution is to consider both value and momentum when constructing your investment portfolio.

Value Indicators

Although not an advocate of market timing, Warren Buffett did comment:

“Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.”

In other words, investors should buy low and sell high. The question, as always, is what determines high and low?

From a stock market perspective, investors emphasize price multiples. These multiples compare the price of a market, sector or security, with fundamentals. For example, earnings (P/E), sales (P/S), cash flow (P/CF), etc.

The average P/E for the stock market is 15x, based on one year of earnings. In their book, "Security Analysis", Benjamin Graham, and David Dodd made the case for using earnings smoothed out over many past years. The purpose is to remove the variations in the economic and business cycles.

Robert Shiller took this analysis to create his cyclically adjusted price-to-earnings ratio (CAPE). It uses ten years of earnings and adjusts for inflation. The lower the reading, the greater the value.

Based on the historical data available to him, Shiller found the average CAPE of the S&P500 to be approximately 16x. The market doesn't spend time at the average, though. Rather it extends beyond (overvalued) and below (undervalued) this average.

From 1881-2011, CAPE has spent 31% of the time in the 15-20 range. More compelling is that the market has spent 90% of its time between a CAPE of 5 and 25.

CAPE Historical Returns

Source: Meb Faber Research, Shiller

The lower the CAPE reading, the greater the potential returns over time. You can see this in the above table. So, as stock market valuation indicators go, CAPE is a good place to start.

Trend Triggers

In the fall of 2012, AQR Capital Management released a whitepaper on Trend Following called “A Century of Evidence on Trend-Following Investing.”

Their tests revealed that buying an asset class when the trend was positive, and selling short when the trend was negative produced a gross annualized return of 20%. Furthermore, the volatility was lower and relationship with the S&P500 was negative. Meaning, reduced risk.

Mebane Faber’s whitepaper, “A Quantitative Approach to Tactical Asset Allocation” also showed how effective momentum strategies are.

Timing Asset Allocation

www.mebfaber.com

Now, replicating the returns in these white papers is unlikely because transaction and slippage costs have an effect. But, they do both highlight the importance of understanding trend and momentum triggers when creating your investment portfolio.

An asset allocation strategy that uses trend following should help investors to outperform the market over time. As important, it should allow investors to mitigate losses.

A word of warning, though.

There are times when trend following will not work. There is no magic bullet and no system is infallible. Gains need time to compound but keeping losses to a minimum, in particular, is critical

The best way to achieve this is through an excellent risk management setup.

Managing Risk in Your Investment Portfolio

Investors have a tendency to focus their attention on information that confirms their beliefs. At the same time, they disregard facts or occurrences that challenge these beliefs. As the price of their investment declines, they remain rooted to the original evaluation.

Think about it. Analysts devote hundreds of hours to undertaking research and writing up detailed reports. Do you think they are going to perform a complete U-turn, days after the release of such a report?

It’s unlikely.

Instead, their assumptions become anchored. They can no longer acknowledge the trends in front of their eyes. Instead, they try to back up their original argument and save face amongst their clients.

As John Maynard Keynes once proclaimed, “When the facts change, I change my mind. What do you do, sir?”

Trailing Stop Losses

Trailing stop losses are important in determining when to move on from a holding in your investment portfolio.

For example, let's assume you believe the trend in Apple to be up and the share price undervalued. Priced at $90, you decide to buy shares. As a way of managing risk, you set a stop loss below this entry point at say, $70.

This stop loss marks the price at which you will automatically sell the shares. Regardless of your previous convictions or analysis of the company. So, your emotions and bias are removed from the equation.

That’s a good thing.

The choice of stop loss strategy differs from investor to investor. But, the goal is the same. Remove losing positions as soon as possible while allowing winning investment advance and compound wealth.

Remember, what matters most to the success of your investment portfolio is not whether you are right or wrong. Rather, it's how much you make when you are right and how much you lose when you are wrong.

Concluding Thoughts on Your Investment Portfolio

The wealthy do something most people don't. They invest wisely and compound wealth through an investment portfolio.

They key is to get started as early as possible and leave compounding work it's magic in later years. 

And yet, many entrepreneurs give little consideration to their investment portfolio. They believe the markets to be too complex and the odds stacked in favor of the larger players, but it's just not true.  

A succesful portfolio is not determined by being right 90-100% of the time. The biggest hedge funds in the world operate with a 60-70% strike rate. Rather, the key is to cut losing positions quickly and let winners run as long as possible.

I've emphasized this above, along with the importance of asset allocation, valuations and trends. However, for a more in-depth explanation, you should check out my free report; Solving the Wealth Equation.

The report covers important investment, authority and business topics and how they relate to wealth building. You can have it for free just by clicking here.

No strings attached. Just my way of saying thanks for your interest and a way for me to boost my credibility and gain your trust.

About the Author James Brooks

James is a digital marketing consultant and online business strategist. He helps coaches, consultants, and solo professionals market their business online so they establish authority positioning and predictably generate 5-20 high-ticket, new clients every month.

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