Three Things You Need to Know to Build Your Custom Portfolio
One of the big questions many investors have is how to invest their money well. Most investors will choose to invest in cash, stocks, and/or bonds, or their packaged equivalents such as mutual funds. In this column, we discuss the three criteria we have found, which matter most to our clients, when determining which of our nine model portfolios are appropriate for a given household.
Those three criteria are risk tolerance, margin, and time frame. Here’s more.
By risk tolerance, we specifically mean your emotional tolerance and ability to sustain the up, and especially down movements, of the stock market. By margin, we mean the amount of discretionary cash flow or assets available to you. By time frame, we mean how many years remain until you need to achieve certain goals.
We measure risk tolerance using a risk profile questionnaire. While the questionnaire itself is simple, much thought has been given to the questions, so the individual and composite answers give a meaningful picture of how much volatility one individual is prepared to experience, without bailing out of a long term investment plan. If you would like to complete this questionnaire, and get a copy of the results, please email email@example.com, and you will receive a link to the questionnaire. The higher the risk tolerance score, the higher the allocation to stocks or equities.
Margin speaks to how well a household handles available cash flow. Uses of cash flow include core living expenses, debt service, taxes, charitable giving, allocated savings, perhaps travel and other discretionary spending, and long term wealth accumulation. Core living expenses, such as housing, food, and transportation, as well as taxes and debt service, are the fixed expenses. Margin is the difference between gross available incoming cash flow, and fixed expenses. Margin is created by the discipline of expense control and delayed gratification, and the preparation of the members of the household to engage in profitable enterprise to generate cash flow. The greater your margin is, the higher the allocation to stocks or equities. If you would like a monthly expense worksheet, email firstname.lastname@example.org, and one will be sent to you.
Time frame is the number of years which remain before you reach the goal for which the funds are being set aside. For most investors, this time frame is the number of years remaining before they want to, or can, retire. The longer your time frame is, the higher the allocation to stocks and equities.
This article isn’t the place for a discourse on the minutiae of how we determine the appropriate model for a household. A summary though, is that the risk profile questionnaire, which scores from 0 to 100, gives us a score which we assign to a model. If there is very little or no cash flow margin, we will generally make the portfolio more conservative by one model. If there is significant margin, we will make the portfolio more aggressive by one model. If the time frame is greater than five years, we can also make the portfolio more aggressive by one model. If the time frame is less than three years, we typically make the portfolio more conservative by one model.
As you evaluate your own situation, good questions can be “What is my actual ability to tolerate the ups and downs of the market?”, “Taking all spending into account, what is our household margin?”, and “When, based on our existing assets and dollars we consistently invest, can we reasonably expect to retire?”.
Randy Brunson, AIF
President of Centurion Advisory Group