Building Optimal Portfolios


Transcript: There’s a lot of advice out there on what stock to buy or what fund to buy. But at the end of the day, you need to remember you’re not buying a stock, you’re not buying a bond, you’re not buying a rental property. What you’re really trying to do is build a portfolio. And the idea of a portfolio is that it’s going to be greater than the sum of its parts.

These are the investments, the engine that drives your financial plan, which ultimately generates your cash flow in retirement. which also generates taxes that you’ll want to minimize. So we’ll go over some examples of how your investments can be used to not only generate income, but also reduce your taxes.

What I want to cover first is a time-tested investment philosophy. And what this means is that there are a lot of different ways to invest, and our belief here at Pure is that you want to find a way to invest that’s based on academic research and empirical evidence, as well as logic. Because if you can do that, then you can have controls in place to manage your emotions.

You can reduce your taxes, and you can generate the cash flow that you need while still sleeping at night. And that’s going to give you a better chance of sticking with that investment philosophy through the inevitable ups and downs you’re going to encounter as you walk that path as an investor. What I want to begin with is key elements of proper portfolio construction.

And really, it all begins with getting the return you need. Think about it this way: if you’re going on a vacation somewhere, yes, you want to get there as directly as possible. If you’re flying, you want less flight delays. If you’re driving, you want less traffic. But really, the first determinant of whether it’s a good vacation is whether you reach your destination.

So the number one goal of investing is that you want to get the return you need that while taking as little risk as possible. And what that is, is having gone through your cash flow planning, there’s going to be a return that matches up with your financial goals. If you don’t get that return across the next years and decades, well, you’re going to run out of money, or you’re not going to meet your goals.

So one of the tools that you can use for this is broad diversification. And that’s owning securities both at home here in the United States and abroad in other countries. Stocks and bonds, real estate, all different asset classes. Of course, you’re going to want to use research, something that you can hang your hat on and say, “Okay, this is an approach that’s worked over time.”

Now, that’s not a guarantee it’ll work going forward, but it’s better than just guessing what the future might hold. And then finally, of course, there’s a lot of uncertainty out there. There’s politics. There’s the economy. There’s international affairs. All of those are beyond your control. But there’s also some factors that you can control on your journey to financial success.


Large Vs. Small Company Stocks


Transcript:  I’m going to walk you through an exercise to talk about how to look at building a portfolio designed to get you the return you need, while also minimizing risk. And now in this example, I want you to pretend there’s only two kinds of stocks. There are large company stocks, and there are small company stocks.

McDonald’s might be an example of a large company, Denny’s is an example of a small company. Let’s furthermore suppose that the large stocks have an 8 percent return, and the small stocks 10%. Now, do the large companies have more volatility or the small? It’s the small. They’re not as established. They tend to be more volatile.

Their prices move up and down more. So let’s for the moment assume you pick the ones that are less risky, the large companies, and then you have two choices. You can buy large company stocks, or you can put your money in the piggy bank. Putting the money in the piggy bank is nice because it has no risk, but it also has zero return.

Remember, we talked about your required rate of return, and for the moment, let’s assume it’s 6%. If you need to get 6 percent on a portion of your money is going in large company, getting 8, and a portion is going to the piggy bank that’s going to get 0. The question then, what portion of your wealth would need to go into those large company stocks?

The answer is 75%, with the remaining 25 going into the piggy bank, giving you a mix of 75/25, and over time you would expect it to get you your 6 percent return. Let’s go back to the small companies for a minute though. Remember, the small companies are more volatile. So we’re not talking about just buying one small company.

That would be too much risk. We’re talking instead about buying a basket of thousands of small companies. And as a whole, some of them will do well, others will do poorly. And over time, you would expect their prices to move a lot. That basket’s going to move up and down more than a basket of large companies would.

But you would also expect that you’ll get higher returns from that basket of small companies. And so if you bought the small companies and that was one option, and the piggy bank was your other option, well in order to get to your 6 percent required rate of return, you would put 60 percent in small companies and 40 percent in the piggy bank.

Stepping back, let’s say you have a million dollars, and it goes in that 60/40 portfolio. You put $600,000 in small company stocks, $400,000 in the bank. Furthermore, suppose you need $40, 000 a year in income from the portfolio. Divide $400,000 by $40,000 and you get 10. 10 is the number of years of spending you have in cash before you have to worry about what the stock markets do.

The bottom line is that by having more diversification within your stocks, you might be able to build a portfolio that’s safer overall and lets you sleep at night.

Benefits of Diversification


Transcript: Let’s shift our attention now to the concept of global diversification. Why might you want to invest in other countries besides the United States? Well, this chart looks at how various countries have performed over the past two decades and then highlights the best performing stock market each year.

What you see is that there was only one occasion on which the United States was the world’s best performer. This speaks to one of the reasons for global diversification. Another reason to invest globally is to smooth out your returns. There are periods when the United States is doing better, and periods when other countries are doing well.

But without a crystal ball, it’s really hard to know what asset class, what country, what investment’s going to do best. Many of the largest fortunes in the world, though, of course, they’ve been made with a single concentrated position where somebody put all their money in one position, put all their chips on the table.

However, keep in mind, that’s a great way potentially to build wealth. It’s not always a good way to maintain wealth. So think about diversification like this: you know the old carnival game, you go and there’s a wall of balloons and you throw a dart at the balloons, and if you pop one you win something?

And usually what you win is a crummy plastic whistle. However, behind a couple of those balloons is a great prize. Maybe it’s a huge stuffed panda bear you can give to your young children or grandchildren. Now the best possible outcome in the game is you walk up, you pay a dollar, you throw one dart, you pop the balloon, and you get the big panda.

But the odds of that aren’t very good, and you’ll probably end up with the whistle. What if instead, though, you paid 20 and you got 20 darts? Well, if you throw 20 darts, your odds of hitting the balloon with the panda have gone way up. Now, you’ve eliminated the possibility of that best outcome of throwing one dart and getting the panda, but that’s diversification.

That’s how it works. When you diversify, you’re by nature lowering the ceiling of possible returns, but you’re also raising the floor. For many, many people looking at retirement savings, lowering the ceiling and raising the floor gives them the best odds of achieving success. Of course, in the carnival game, nobody knows which balloon has the big panda.

But what if the person working at the stand said, “Hey, I’ve been working here for ten years, and I can tell you that more of the pandas won have come from the yellow balloons.” You might not throw all your darts at yellow balloons, but in that example, you’d probably throw a few more, thereby increasing your odds.

You’re relying on what’s happened in the past to guide you a little bit going forward.

Using Research to Your Advantage


Transcript: Now, academics around the globe have studied characteristics of financial markets and companies, and one thing they found is that over time, stocks do better than bonds. That makes sense, right? If you invest in the stock market over 20, 30, 40 years, you’re probably going to do better than investing in bonds or cash.

Of course, it’s going to be more volatile, it’s going to be a bumpier ride, and there’s even years in which stocks have fallen significantly, or when cash or bonds have done better than stocks. But again, you’re focused on the long run, and you expect that in return for the volatility, you’re going to get better returns from the portfolio stocks than cash or bonds.

Let’s look deeper. Academics have found that even within the stock market, there have been certain kinds of companies that have done better than their peers. For instance, more profitable companies have done better than less profitable ones, and that makes sense. Less expensive stocks, those are known as value stocks, have done better than more expensive stocks, which are known as growth stocks. And that, again, makes sense, right? If you have two comparable items and one is on sale, wouldn’t it be a better purchase? That’s logical. The irony, though, is that if you think about the mall when people used to go to malls, if you went on the Wednesday before Thanksgiving, nobody was there.

But if you went on the Friday after Thanksgiving, it was packed. People love a sale in every area of their life except when it comes to investing. And then there are small companies. Small companies have done better than large companies over time. Flipping over to the bond side, academics have found certain tendencies there as well.

For instance, longer maturity bonds have done better than shorter maturity bonds. Less creditworthy companies have produced higher returns than more creditworthy companies. Again, this is all logical. If you were lending your friend money, the longer you lent them to, the more risk you’d be taking. The lower your friend’s FICO score, probably, the more risky it is as far as them paying you back.

But you’d need more return then. If you were going to take on more risk lending, you’d want more return. Same way it works in the bond market. Now, you want to position your portfolio so you can take advantage of this academic research. And that’s also going to enhance your diversification and potentially give you better outcomes in some environments.

Here’s an example of when that would have really helped you. This is called the Lost Decade¹, and that’s the period from 2001 to 2010 during which the S& P 500, which is mostly large company growth stocks, experienced negative returns over the course of a decade. The reality, though, is that it was only a lost decade for investors that had concentrated all their money in large U.S. growth companies. Many, many investors do this, so you might want to look at your own portfolio, see how you’re invested, make sure you’re not concentrated only in those large growth companies. Because think back to that Lost Decade. If instead of investing in the S& P 500, you had invested in international companies, you’d have gotten a 27 percent return.

In the U. S., we talked about the S& P 500 losing money. Well, large value companies made 50%. Nobody likes bonds. Everybody complains the returns are too low, and yet during the Lost Decade, here’s an example of why you own bonds. Think about it. Somebody that was trying to generate a paycheck from a portfolio in the S& P 500.

Not only are they pulling income from that portfolio every year, but the value is declining along with the market. Owning bonds during that decade, you might have been living off the part of your portfolio that was up 80 percent like bonds were, giving stocks time to recover. Of course, we all know real estate, right?

Big decline in 2008 led to the financial crisis. But for that decade, real estate investment trusts were up 175%, emerging market stocks and U. S. small company value stocks, up 200 percent plus. And what about the big winner? You definitely didn’t have a lost decade if you invested in emerging market value companies that soared over 400 percent in that decade.

That’s the panda bear. That would have been if you put all your money there, paying a dollar and getting lucky. But if instead you own some of everything I just discussed, that’s walking up to the darts, throwing 20 worth, getting the panda bear, and getting a successful outcome.


Control What You Can Control


Transcript: I also want to talk to you about some of the elements that are within your control with investing. Rebalancing, asset location, tax gain and loss harvesting, tax projections, and generating income. These are parts of your overall investment program that are completely within your control. If you don’t maximize those, you’re leaving money on the table and you’re not optimizing your future financial outcomes.

Let’s talk about rebalancing. Think about a portfolio that started 50 percent stocks, 50 percent bonds, and then over time you’re in a bull market, the stocks increase, now it’s 70 percent stocks, 30 bonds. You haven’t done anything, but over time your portfolio has moved out of bonds, you’ve taken on more risk, but what now if the stocks suddenly fall?

What if now you’re in a bear market at a time when you have way more risk in your portfolio than you planned? So you need to have a method for keeping your portfolio in alignment. Think of it like a ship. Ship sets out on a journey. The captain along the way is going to need to correct course as the wind or the waves push them off course.

Otherwise, they’ll never wind up where they want to go. That’s rebalancing. Asset location, what that is, is holding different kinds of investments in different types of accounts. Maybe you have a brokerage account. You have a Roth IRA. Maybe you have a 401k or a pre-tax IRA. There’s different types of investments that make sense in different types of accounts.

The higher return investments might go in the Roth, where you’re never going to pay taxes on those gains. Maybe the lower return investments go in the IRA. And then in that brokerage account, tax gain and tax law harvesting comes into play. As markets move up and down, you can take a look and see if it makes sense to harvest either gain or a loss.

That’s one way you can minimize the taxes you’re going to pay down the road in your investment portfolio. Of course, to do that properly, you need to be looking at what your future tax brackets will be, and that’s part of the planning process, part of tax projections, but it’s intricately linked with your investments, because at the end of the day, your taxes and your investments move together, and that combination determines the quality of your retirement.

Of course, at some point, you’re going to need to live off this money. That’s why you’ve saved. You’ve gone to work every day for decades, and every two weeks you got a paycheck. Now you’re retired, what do you do? That’s one of the biggest challenges people face. How do you go from an employee where you’re getting paid to somebody that has to live off the accumulated savings?

Oh, and by the way, you can’t mess up. You can’t make a mistake because if you do, you’re going to run out of money at a time when you can’t go back to work. Of course, the flip side is that you also don’t want to underspend too drastically. You wind up saving too much money, not enjoying it. Life’s short.

You want to enjoy your retirement. So how much cashflow can your portfolio support? Again, that’s a function of financial planning and cashflow planning, but how you actually generate that paycheck. That’s where the investments marry the planning and come together to provide the tax efficient income you need in order to retire.

Of course, having pulled money out of your portfolios, you need to then rebalance the portfolio, adjust it accordingly to account for where the distributions came from. All this putting it together is really one of the keys to meeting your financial goals across the course of your retirement. Again, the key to investing is not to lose the forest for the trees.

There’s so much noise out there. You need to ignore the noise. You need to ignore the hype. And then you need to find a disciplined approach to building a portfolio where the holdings become greater than the sum of the parts. A portfolio that is going to help you meet your financial goals, get your required rate of return, while most importantly still allowing you to sleep at night.

1. Source: “A Tale of Two Decades: Lessons for Long-Term Investors.” 2023 Dimensional Fund Advisors. [Last Accessed: January 11, 2024]