This is the first in a series of 7 posts that will describe how to design and implement your own personal portfolio.  Many beginning investors feel so helpless with this task that, in retrospect, always seems so easy, that they run to a financial advisor for assistance.  Unfortunately, some writers suggest as many as 93% of financial advisors are simply salesmen, and so many of these naive investors don’t get started off on the right foot.  Hopefully, after finishing this series, you’ll be prepared to design and implement a simple, yet sophisticated, portfolio yourself, or at least gain the skills and knowledge necessary to know when an advisor is “selling you down the river.”

Set Specific Goals

The first step in designing a portfolio is to set a goal for that portfolio.  It might be to pay for your retirement, to pay for your child’s schooling, to buy your first house, to make a charitable donation at your death, or even to leave a certain amount of assets to your heirs when you pass.  The more specific the goal, the better.  You want to not only specify exactly how much money you need, but also, the exact date when you need it.  An example of a good goal is “I want to have $100,000 in junior’s 529 plan on September 1, 2023.”  Examples of a poorly-defined goal include “I want to be able to retire someday”, “I want to make as much money as possible with my investments,” or “I want to be a millionaire.”

Plan For Change

Naturally, life circumstances and goals change as the years go by.  That’s okay.  Goals, plans, and portfolios aren’t set in stone.  If you let the fact that the plan will probably change later keep you from instituting it in the first place, you won’t reap the benefits of actually making a plan.  Plus, if you never actually calculate how much you need to save toward a goal, you will almost certainly err on the side of saving too little, keeping you from ever reaching your goal.

Plan for Inflation and the Sequence of Returns Issue

If your goal is less than 5 years away, you’re probably okay ignoring inflation.  Anything longer and you should use “real” or after-inflation numbers.  That means if you calculate you need to save $20K a year to reach this goal, that’s $20K in today’s dollars, so you’ll probably have to contribute a little more each year.  When you calculate the return you need, you will also need to use a lower, after-inflation return.

When saving for any goal, the sequence of returns matters.  That means that ideally you get lower returns early on, when the amount of money saved is low, and higher returns later when the nest egg is large.  Calculations like those I’m going to show you are by nature simplified, so recognize their limitations.  Also, keep in mind that financial markets are not like physics.  They are complex social institutions and there are precious few guarantees.  There is a reasonable chance that the future will be very dissimilar from the past, so view past data with a very skeptical eye.

How Much Do You Need Saved?

You’ll have to make some kind of estimate for the amount you need to save.  For a house you want to buy in 3 years, that may be relatively easy.  You look at the price of similar houses, calculate the amount you’ll need for 20% down, maybe add a few percent more in case the value goes up (does that happen anymore?) or for closing costs, and there you go.

As the goal gets more complex, so does the estimate.  For example, if your goal is to pay for tuition at your alma mater for your 3 year old, you’ll need to make some assumptions.  Let’s say 4 years of tuition right now is $40,000 and you think tuition will go up at an amount 2% over the general rate of inflation.  Pull out your favorite spreadsheet, such as excel, and put this into a cell:



The first number is the annual return.  The second, the number of years.  The third, the amount paid in each year, and the last the amount you have now.  So this calculation will tell you what that $40,000 tuition bill will be in 15 years.  So you need $54,000 in today’s money to reach that goal.

Estimating the amount for your retirement nest egg is even more complex.  Many studies and even entire books have been written on the subject.  But the basic process is that you estimate how much money you will need to spend each year in retirement, subtract the amount you expect from any guaranteed pensions or Social Security, and then apply a “safe withdrawal rate” such as 3 to 4.5% per year.  For example, you estimate you’ll need $100K per year in today’s dollars, you have no pensions, and you expect Social Security to contribute $30K per year, indexed to inflation.  Thus, you need your portfolio to contribute $70K per year, indexed to inflation.  You decide, after looking at the studies, that you’re comfortable with a 3.5% withdrawal rate.  $70,000/0.035= $2 Million.  So your goal might be “I want $2 Million (in today’s dollars) in retirement savings by July 1st 2030.”

Don’t Take Shortcuts

This step seems very basic, but it is frequently skipped, leading to numerous problems down the line in the process of portfolio design.  The process is simple, but it is critical that you take it in order.  First you set goals, second you develop an asset allocation, third you implement the asset allocation, and last you maintain the plan.  We’ll be evaluating each of these in turn.  The next post in this series will discuss the relationship between how much you need to save and the portfolio return you need, and thus the risk you need to take.