Portfolio Construction
Building and maintaining an investment portfolio aligned with your goals.
The Goal of a Portfolio
A portfolio should:
- Match your risk tolerance
- Achieve your return objectives
- Be diversified against various risks
- Be simple enough to maintain
- Minimize costs and taxes
Asset Allocation
What Is Asset Allocation
Your mix of different asset types:
- Stocks (domestic, international)
- Bonds (government, corporate)
- Real estate
- Cash
- Other (commodities, alternatives)
Asset allocation determines 90%+ of portfolio returns over time.
Factors That Determine Allocation
| Factor | More Stocks | More Bonds |
|---|---|---|
| Time horizon | 20+ years | Under 5 years |
| Risk tolerance | High | Low |
| Income needs | Low | High |
| Job stability | Stable | Unstable |
| Other assets | Pension/home equity | Few other assets |
Sample Allocations by Age/Risk
| Profile | US Stocks | Int'l Stocks | Bonds |
|---|---|---|---|
| Aggressive (20s-30s) | 60% | 30% | 10% |
| Moderate (40s-50s) | 45% | 25% | 30% |
| Conservative (60s+) | 30% | 15% | 55% |
Adjust for your situation, not just age.
The Simple Portfolios
Three-Fund Portfolio
The classic Boglehead approach:
| Fund | Purpose | Suggested Range |
|---|---|---|
| US Total Stock Market | Domestic equity | 40-60% |
| International Stock Market | Global equity | 20-30% |
| US Total Bond Market | Fixed income | 20-40% |
Why it works:
- Extreme diversification
- Ultra-low cost
- Simple to maintain
- Hard to beat
Target-Date Funds
All-in-one funds that adjust automatically.
Example: Target 2045 Fund
- Starts aggressive (90% stocks)
- Gradually becomes conservative
- "Set and forget" simplicity
Best for: 401(k) investors, hands-off approach
Two-Fund Portfolio
Even simpler:
- 60-80% Total World Stock Index
- 20-40% Total Bond Index
One stock fund covers US + international automatically.
Diversification
Types of Diversification
| Type | How |
|---|---|
| Asset class | Stocks, bonds, real estate |
| Geographic | US, international, emerging |
| Sector | Tech, healthcare, financial, etc. |
| Size | Large, mid, small cap |
| Style | Growth, value |
| Time | Dollar-cost averaging |
Correlation
Assets that move differently provide better diversification.
| Assets | Correlation | Diversification Benefit |
|---|---|---|
| US Stocks & Int'l Stocks | High (~0.8) | Low |
| Stocks & Bonds | Low (~0.1) | High |
| Stocks & Gold | Low (~0) | High |
| Large Cap & Small Cap | High (~0.9) | Low |
Key insight: Stocks + bonds together reduce volatility significantly.
How Much Diversification
| Number of Stocks | Diversification |
|---|---|
| 1 | None (maximum risk) |
| 10 | Significant reduction |
| 30 | Most company-specific risk gone |
| 500+ | Market risk only |
| 10,000+ (total market) | Maximum diversification |
Index funds give instant maximum diversification.
International Allocation
Why International
| Reason | Explanation |
|---|---|
| Diversification | Different economies, currencies |
| Opportunity | 40%+ of global market is non-US |
| Valuation | Sometimes cheaper than US |
How Much International
| View | International Allocation |
|---|---|
| Conservative | 20% of stocks |
| Moderate | 30-40% of stocks |
| Market weight | 40% of stocks |
Common choice: 20-40% of stock allocation in international.
Emerging Markets
Higher risk, higher potential return.
| Approach | Allocation |
|---|---|
| Through total international fund | Included (~25% of int'l) |
| Separate allocation | 5-10% of total portfolio |
Rebalancing
What Is Rebalancing
Returning portfolio to target allocation when it drifts.
Example:
- Target: 70% stocks, 30% bonds
- After market rise: 80% stocks, 20% bonds
- Rebalance: Sell stocks, buy bonds to return to 70/30
Why Rebalance
| Benefit | Explanation |
|---|---|
| Control risk | Prevents portfolio from becoming too aggressive |
| Buy low, sell high | Forces selling winners, buying underperformers |
| Discipline | Removes emotion from decisions |
Rebalancing Methods
| Method | How It Works |
|---|---|
| Calendar | Rebalance annually (or quarterly) |
| Threshold | Rebalance when allocation drifts 5%+ |
| Cash flow | Use new contributions to rebalance |
Recommendation: Annual rebalancing or 5% threshold.
Tax-Efficient Rebalancing
| Priority | Method |
|---|---|
| 1 | Direct new contributions to underweight assets |
| 2 | Rebalance within tax-advantaged accounts |
| 3 | Sell in taxable accounts (trigger taxes) |
Factor Investing
What Are Factors
Characteristics that explain returns:
| Factor | Description | How to Access |
|---|---|---|
| Market | Overall stock market exposure | Total market index |
| Size | Small caps outperform (historically) | Small-cap funds |
| Value | Cheap stocks outperform (historically) | Value funds |
| Momentum | Recent winners continue (short-term) | Momentum funds |
| Quality | Strong companies outperform | Quality funds |
Simple Factor Tilts
If you want to tilt beyond total market:
| Tilt | How | Caveat |
|---|---|---|
| Small-cap value | Add small value fund (10-20%) | Higher volatility |
| Total market + value | Overweight value funds | May underperform growth |
Most investors: Total market is sufficient. Tilts are optional.
Building Your Portfolio
Step-by-Step
- Determine allocation based on goals/risk
- Choose funds for each asset class
- Select account types (tax-advantaged first)
- Invest consistently via automation
- Rebalance annually or at thresholds
- Review periodically but don't tinker
Fund Selection Criteria
| Criterion | Target |
|---|---|
| Expense ratio | Under 0.20% (ideally under 0.10%) |
| Diversification | Broad index preferred |
| Tracking error | Low (matches index) |
| Tax efficiency | Index funds, ETFs |
Sample Implementation
$100,000 portfolio, age 40, moderate risk:
| Asset Class | Allocation | Fund Example |
|---|---|---|
| US Stocks | 45% ($45,000) | VTSAX or VTI |
| Int'l Stocks | 25% ($25,000) | VTIAX or VXUS |
| US Bonds | 25% ($25,000) | VBTLX or BND |
| REIT | 5% ($5,000) | VNQ |
Total expense ratio: ~0.06%
Common Portfolio Mistakes
| Mistake | Problem | Solution |
|---|---|---|
| Too complex | Hard to manage, higher costs | Simplify to 3-5 funds max |
| Overlapping funds | Paying more for same exposure | Check what's in each fund |
| Performance chasing | Buy high, sell low | Stick to allocation |
| Too frequent trading | Taxes, costs, poor timing | Trade rarely |
| Ignoring costs | Fees compound against you | Index funds only |
| Home country bias | Under-diversified | Add international |
Lifecycle Investing
In Your 20s-30s
| Focus | Action |
|---|---|
| Aggressive allocation | 80-100% stocks |
| Max contributions | 401(k), IRA, HSA |
| Time is ally | Volatility is opportunity |
In Your 40s-50s
| Focus | Action |
|---|---|
| Moderate allocation | 60-80% stocks |
| Catch-up contributions | Max tax-advantaged |
| Prepare for retirement | Model income needs |
In Your 60s+
| Focus | Action |
|---|---|
| Conservative allocation | 40-60% stocks |
| Income planning | Match assets to withdrawals |
| Sequence risk | Manage withdrawal timing |
Key Takeaways
- Allocation drives returns - Most important decision
- Simple beats complex - 3-4 funds is plenty
- Low costs win - Index funds dominate
- Diversify broadly - Don't concentrate
- Rebalance regularly - Annual is fine
- Stay the course - Don't time the market
- Match to goals - Risk tolerance and timeline