There are many nuanced factors to consider when figuring out how to build a retirement investment portfolio. In this episode I go over some of the more important foundational building blocks, and how to begin the process of creating a retirement portfolio for you.
More specifically, I discuss:
- Identifying a specific purpose for your different accounts, based on your financial plan
- Factoring in personal preferences when determining your portfolio allocation
- The goal of diversification
- Types of asset allocation
- Asset location and practical use cases
Resources From This Episode:
How to Build a Retirement Investment Portfolio
Hey everyone. Welcome to the Retired-ish Podcast. I'm your host, Cameron Valadez, back again today for another actionable episode where my goal is to provide you one or two nuggets that you can take and see if it makes sense to implement them into your retirement plans.
Today we're talking about your investment portfolios in or near retirement and how you should build them. Now, typically, when I mention your portfolio, I'm talking about your overall portfolio, which would include investable assets like retirement accounts, trusts, regular brokerage accounts, and other investments such as real estate, for example.
But when I refer to your investment portfolios, I'm referencing only the investments in your overall portfolio that are typically more liquid, such as your stocks, bonds, funds, CDs, and the like. So not your real estate or any investments in private businesses, maybe. However, I want to caveat that your investment portfolio should be invested in a way that complements whatever else may be included in your overall portfolio. It's the overall portfolio allocation and performance that will drive your net worth up or down over time, and increasing your net worth is the name of the game.
Now, your investment portfolio isn't usually made up of one account. Most people in or nearing retirement have assets accumulated in multiple accounts and for different reasons. For example, you could have a 401(k), a Roth IRA, maybe you or your spouse has an inherited IRA, and maybe a joint account as well. All of these would make up your investment portfolio even if the accounts aren't held at the same place. So hopefully, you have a specific rhyme and reason for the different accounts that you own, as well as the investments inside them. If you don't, though, this episode was created especially for you.
So, let's dive into how we should actually go about designing our investment portfolios. So, when setting up your investment portfolios, the first step is not to just start randomly investing, you need guidelines or a purpose for each account type and the basket of investments that you choose inside those accounts.
If you know me or receive our monthly Retired-ish newsletter, you know that I harp on purpose, purpose, purpose when it comes to investing. You should have some sort of financial plan in place, or at least what is called an investment policy statement. This is generally a brief statement that you create that is basically a rule set, or guideline for you to refer back to that explains what the goal or the purpose for that particular investment is.
Typically, you would have one of these per account that you have. So, for example, is it to grow over time to fund a purchase or produce income to live off of, et cetera, et cetera? If you have developed a comprehensive financial plan that you maintain every year and you actually monitor, your plan can sometimes serve as your investing guide. Preferably, this isn't a like a fly by night plan, and it's one that actually addresses all of your realistic goals as well as the risks that threaten those goals. After you have a specific plan or purpose in place for your different buckets of money, only then should you start deciding what types of accounts you should have and the investments that will make up those accounts. This is especially true given the fact that there are literally tens of thousands of different investment options out there. Without any guidelines whatsoever, how on earth are you going to know which ones are right for you?
Trust me, I know this may sound rudimentary and boring, and you're probably saying yeah, yeah, yeah, I know, but believe me. When I ask investors, no matter how savvy they may hold themselves out to be, what the purpose is for a particular investment or account, they hardly ever have an answer other than something along the lines of to grow and make money. Now, of course, that is the main goal of investing in general, but that is far too vague. It needs to have a more specific purpose. That way, you have better expectations of risk and reward down the line, which will also prevent you from making damaging investing mistakes down the line as well. Now, there's kind of an easy way to check yourself to see if you lack a specific enough purpose for your investments or a plan, and that is that if your lifestyle and or your sanity is dependent on short-term market returns, so like within a year or so, then you likely lack specificity in your plan.
So how do we get more specific? Most would start with a conventional asset allocation mix of stocks and bonds, such as 60% in stocks and 40% in bonds in cash in their portfolio. However, there is much more to it than that. While there are copious amounts of research in existence about different asset allocations, like the 60/40 portfolio, you should first take personal preferences into context as well as other investments you may have in your overall portfolio. Like I mentioned before, your portfolios need to play well together in the sandbox. An example of personal preferences could be high-cost debt, for example. If, say, you had or have a mountain of high-cost or high-interest consumer debt, such as credit card debt that ranges from the teens to 20% or more, it really wouldn't make any sense to own a lot of bonds in a non-retirement account, paying you low single digit interest. When instead, you could tackle that debt first and save multiples compared to your bond’s interest payments. Another example might be that you own a business that is very cyclical, meaning it ebbs and flows and sync with the US economy, and therefore when the US economy goes into a recession, your business also suffers pretty significantly.
In this case, if you rely on that business income, you probably don't need to take a ton of what I would call cyclical risk in your investment portfolio, either. So, if you were to own US stocks and, more specifically, those stocks in the consumer discretionary sector of the US economy, you would basically be doubling up your overall portfolio's risk. Instead, you might consider scaling back US stock exposure and, even in that case, allocating to other sectors of the economy that do not ebb and flow with your business or ones that are not highly correlated to your business. Or maybe no US stocks at all, right? There's many ways to go about this.
Personal preferences can also be forward-looking. So, for example, in practice, I find that many of today's retirees are inheriting at least some sort of asset from their parents, which would be the silent generation. Their parents lived through the Great Depression and taught them valuable lessons about money.
Therefore, the silent generation specifically was phenomenal at socking away money, whether it be in the mattress, invested in the markets, you know, real estate, gold, silver, you name it. If you are at all involved in your parents' finances, like maybe you're helping them tap their assets to pay for home healthcare or something like that, you likely already know what you stand to inherit if there's anything left, and what and how it is invested in.
Or maybe you currently help them make investing decisions, just in general. If you're in a situation like that, you may tailor your own investment allocation to complement your potential future inheritance. I actually have a great case study to share with you on this one. Recently I was talking with someone in their mid-fifties who was what we call a trustee, along with his widowed mother on her trust. Now, she was also a trustee on that trust. Therefore, he helps her make investment decisions in that trust on an ongoing basis. Now she's in her early nineties, after all, and even though she's doing great, this is probably a good idea for her best interest that her son is also a trustee with her. Now, when we took a look at the portfolio, we noticed that about half of it was in municipal bonds. The other half was mostly a diversified basket of stocks. Now, when we asked about the purpose of the money in this account, they paused and looked at each other, and the mother said that it would be primarily for he and his siblings, the son, to inherit. There was really no current need whatsoever. In addition, we also reviewed their tax return to find out that she also had a small real estate portfolio, low income, and a zero tax liability.
Now looking at this from a professional perspective, two things immediately came to mind. Why are there bonds in the portfolio at all? What was their purpose for being there, and why were they municipal bonds, especially when she had no tax liability? They didn't have a specific reason for owning the bonds since volatility didn't matter due to the fact that the money was purely for inheritance purposes down the road. And remember that the benefit to municipal bonds is that they typically pay tax-free interest. However, this is normally only beneficial if you are in some of the highest federal and possibly state tax brackets.
In addition, the kids inheriting the money were all well off in their own right, and they would all likely use the money that they inherited for their own care later in their life or even to pass to their kids. This meant that the investment timeframe for this bucket of money was about 20 or more years.
Now when we explained our concerns with this, they both agreed that they should probably allocate it differently. And note that just because someone may be older, so the mom in this case, in her early nineties, and have a shorter investment time horizon if we only considered her age, that doesn't necessarily mean that her various investment portfolios should be more conservative. That's generally just a rule of thumb that's thrown around out there. The point is that constructing your investment portfolio with personal preferences in mind can be very beneficial due to the fact that you will be more astute to the overall risks in your portfolio, and you will be more likely to stick to your investment policy statements or plans even amidst the utmost uncertainty. And as a side note, personal preferences should not be confused with overconfidence. So said, another way, a personal preference is not that you prefer to invest in only, say, real estate or only stocks and not real estate. That would be your personal overconfidence in that asset class. That is not a personal preference.
So now let's talk about diversification of your investible assets. After you've identified what actual amount of money can be invested and what kind of risks you should or shouldn't be taking due to other personal preferences, now it's time to figure out where to allocate the money, generally speaking. Diversification is often referred to as your only free lunch when it comes to investing. However, please note that diversification by no means will guarantee you less risk or more return. It's simply a more prudent way to go about investing. The goal of diversification is to refrain from putting all of your eggs in one basket, as they say. And in addition, having enough diversification so that when one asset class does poorly, hopefully, another isn't, or other asset classes you own are possibly moving in the opposite direction, which would reduce your overall volatility over time.
So, for example, if you are going to own bonds primarily for diversification purposes, in a portfolio of yours that also includes stocks, you may want to be sure you own the types of bonds that are the least correlated to the stock market. If everything in your portfolio acts the same or is highly correlated to one another all the time, you're likely not as diversified as you could be. Now diversification seems rather simple on the surface, but it's not as easy as it sounds. In fact, a lot of investors think they are properly diversified when they really aren't. More on that later.
Once we have identified a purpose for any particular bucket of money or account, we can identify and decide on what kind of return do we need to aim to achieve with this investment and, therefore, how much risk do we need to take. Typically, the higher the risk, the higher the reward, and vice versa. Diversification will play a large role in fine-tuning your portfolio's risk and reward characteristics. If you're creating a retirement portfolio whose goal is to help you supplement your retirement income over a 20 to 30-year retirement, your desired return is going to depend upon the amount of the regular withdrawals that you'll need, depending on your lifestyle. You don't want to drain the account too quickly, of course, and possibly run out of money too soon, which is a retiree's worst fear, or take too little and leave a bunch of money on the table when you die. Now, that desired return is also going to dictate the appropriate level of risk you will have to take to possibly achieve those returns. However, nothing is certain when it comes to investing.
If, for example, you have a $1 million portfolio in investable retirement assets and you need to live on $55,000 a year gross before taxes, that would equate to almost a 4% rate of return on average over a potential 30-year timeframe. Now, theoretically, this means that the $1 million, whether that's in one account or multiple, would need to generate at least a 4% average return over that time period. But most importantly, this also means that you would only need to take the commensurate amount of risk to potentially earn that average 4% rate of return. Now, this is just a very basic hypothetical example, of course, and it doesn't factor in inflation, in which case the rate of return in this example would need to be higher. But this is crucial to understand. I can't emphasize this enough. An easy way to explain this concept would be to use a hypothetical example and look at the performance history of a particular stock in a company that has been around for decades and look at the annual returns. You will likely find them to be all over the place. Some years the stock may have produced a 10% rate of return, 13 and a half, negative 23, positive 75 maybe, et cetera, et cetera. It'll be all over the place. But you might also be able to locate an average return for the stock over a 20 or 30-year time period if it's been around that long, and you may find that that average return is, say, 15%.
Now, theoretically, that stock would've provided you with more than enough total return for your income goal because, in my previous example, you only needed four percent. But more importantly, that goal would've been achieved with far greater risk and volatility along the way. Now, in this example, could you still earn enough of a return for your income goal while at the same time reducing risk, even if it's a little bit when compared to the single stock scenario? Yes, very likely through a diversified allocation to various different asset classes.
Now asset allocation, as we call it, can be big picture, and it can be very granular. I would say start big picture and work your way down. In my opinion, big picture would include the different broad asset classes such as stocks, bonds, cash, maybe insurance for risk reduction purposes, et cetera.
And what you're looking to do is develop a mix of those different asset classes in your investment portfolio that, when working together, they can help you to reach your desired long-term returns. But also, it can allow you to mitigate the amount of risk in order to do so. So, like in my earlier hypothetical example, instead of owning one single stock or even a couple, you can have a mix of not only hundreds of different stocks, but you can also include other asset classes as well, like bonds or CDs and a mixture of cash, for instance, which will likely reduce the risk being taken. Sometimes substantially. It could be fairly complicated. I will warn you to figure out the historical risk and return metrics as well as current risks to your investment portfolio on your own. So, more often than not, you will likely need some sort of professional software to help you determine those things or maybe work with a professional to help you do so. But in either case, this information is widely available to investors in today's environment. There are many DIY platforms online that have ways to see these kinds of details if you prefer to do it that way. Now, you may be saying, yes, I have broad diversification already. I've tackled that because I use investment funds for my investing. An example of these could be mutual funds, index funds, or ETFs, also called exchange-traded funds, et cetera. And while it is true that these funds usually own many different investments and can be a quick and easy means of diversification, owning them doesn't necessarily mean you are diversified.
So now, let's look at an example of the more granular aspects of asset allocation, which refers to the different types of stocks, bonds, and funds, such as the geographical location. So, I'm giving you just one example to illustrate my point, but please know there are many different, call them subclasses of these investments, such as company size, you know, government versus corporate bonds, et cetera.
So, while you may have, let's say, five to ten investment funds like I just mentioned, and each one of those owns a basket of individual stocks and bonds and the like, a lot of them may own the exact same stocks, bonds, and the like. The most common scenario where I see this mistake is when someone has like a domestic index fund that tracks the S&P 500 Index for their large-cap stock exposure. And then they also own a global mutual fund to get some more diversified exposure to international stocks. However, when you actually look into the individual stock holdings of each of those funds, you find that the top three to five holdings are in the exact same companies. In this scenario, this can happen because global, the word global does not exclude US companies, global means global. So, it's international, other countries, and the US.
So, you wanna be careful of simple mistakes like these that can easily catch you off guard. Not only that, but when you look at the percentage weightings of those stocks in any given fund, the top three to five or, or actually more commonly, the top 10 holdings, typically make up a huge chunk of the entire fund, even if it owns several hundred different stocks.
So, if you have a fund where 45% of it is actually in the top three stocks, and you own another fund that also owns those same stocks, and they make up 25% of that fund overall, are you really that diversified? Likely not. These types of funds aren't necessarily bad investments. I'm not saying that at all. You just really need to understand how to use them or at least get help on how to use them. It’s often the case where on the surface, it looks like our eggs aren't all in one basket when in reality, a lot of them are. So I want you to recognize early on in your retirement investing journey that this false sense of diversification will be particularly hard to see and acknowledge when markets are doing well. When you're making money, you don't pay as much attention to the possible risks you're taking. You're focused on the money. Why fix what doesn't seem to be broken?
It is usually only after you have suffered a market downturn or losses when you begin to assess the real risks that you're taking, and your true diversification don't make this mistake.
One final aspect to building out your retirement investment portfolios is referred to as asset location. Now, this isn't to be confused with the previously mentioned asset allocation. So, asset location is like the smarter sister. This refers to the process of allocating those broader asset classes I mentioned between specific account types, such as tax-deferred retirement accounts like 401(k)s, IRAs, Roth IRAs, et cetera, versus the annually taxable accounts like the trusts and brokerage accounts. And this is mainly in order to improve tax efficiency.
So, here's an example. You may have an investment portfolio comprised of a joint brokerage account in which any earned interest, dividends, and or capital gains you may realize are taxed each year, and you and your spouse may also each have an IRA in which the money you withdraw is taxed when you take it out. So, you have three accounts total in this example. Now, after following the steps previously discussed and identifying your uses for the money, you determine that your broader asset allocation mix for your investment portfolio should be about 50% in stocks and 50% in bonds, CDs, and cash. At the onset, the logical thing to do would be to allocate each individual account 50/50 when in fact, it would likely be more tax efficient to allocate the 50% or so in stocks to the joint brokerage, non-retirement account, and the 50% in bond CDs in cash to the tax-deferred retirement accounts. In this case, you are still diversifying in the same way, the 50/50. However, you are considering all of your different account types as one investment portfolio.
So why can this be more tax efficient? Well, this is primarily due to the way different types of investment income is taxed. Generally speaking, in a non-retirement, non-tax deferred account, a lot of the dividends paid from your long-term stock holdings can be considered qualified dividends and therefore get taxed at more preferential capital gains tax rates. Now, this is typically 15 for most, but it can be as low as 0%. It could be 20% for those of you in the highest tax brackets, and sometimes there might be an additional Medicare surtax of 3.8%, but for the most part, it's usually 15%. You also will only pay capital gains taxes in those non-retirement accounts if you choose to sell securities at a gain.
Now, on the other hand, bonds, CDs, and even real estate investment trusts, also known as REITs, and even the interest that your money market account might generate throughout any given year, all of this is taxed as ordinary income, which means it is taxed at your regular, federal, and possibly state income tax rates, which are typically higher than the more preferred capital gains rates.
So, if you primarily own ordinary income-producing securities in your non-retirement accounts, your non-tax deferred accounts, they will produce a lot of ordinary taxable income every year, which is taxed at less favorable tax rates. Instead, you could consider allocating more of your portfolio's stock waiting in these non-retirement, non-tax deferred accounts so that you decrease the amount of ordinary income being recognized each year for taxes, as well as taking advantage of the more preferential tax rates available to the dividends of certain stocks. Now, on the flip side, the type of income and or capital gains that happen inside a tax-deferred account, like a 401(k) or an IRA, doesn't necessarily matter. Now that is because these accounts, the income tax treatment depends on the type of account, not the investments themselves inside. As the investments inside generate income or have capital gains, the tax is deferred, hence the name deferred account, until you take the money out. You don't recognize it each and every year. If the account is a pre-tax account like a traditional IRA or regular 401(k), balance pretax, any and all of the money withdrawn is going to be subject to ordinary income taxes in the year withdrawn.
Again, it doesn't matter where the money came from, whether it was dividend money, interest, or money from the sale of a stock or a bond, et cetera. The only caveat to this is if you have any, what we call basis in your pre-tax retirement accounts. An example of this might be a previous nondeductible IRA contribution you may have made in the past for whatever reason, and any basis withdrawn from a tax-deferred retirement account would generally not be taxed again when it's withdrawn. But again, that's one of the very few caveats. So, in the case of tax-deferred accounts, owning what would otherwise be tax-inefficient assets like bonds, REITs, or CDs, for example. It doesn't necessarily matter. They will be taxed the same way either way because of the fact that they are in the tax-deferred account. When the money comes out, it's gonna be taxed as ordinary income.
Then there's the Roth-based accounts in which the money, whether it's contributions, conversions, or earnings in the account, is generally not taxed when taken out as long as you meet the basic rules for a qualified Roth distribution. And I've included a link to those rules in more depth in today's show notes. We could do a whole episode on that. So, check that out if you're wondering what those rules are and how they might apply to you. Now asset location can drastically improve today's tax efficiency by allowing you to better manage your taxable income. Not only can it reduce your tax bill, but it can also help you avoid other tax traps, such as more taxation of social security income and Medicare premium surcharges, also known as IRMA. In general, it can also help reduce your adjusted gross income or AGI, which can allow you to more easily qualify for certain other itemized deductions. Identifying specific purposes for each of your accounts, personal preferences, diversification, asset allocation, and asset location are some of the foundational building blocks for creating a better retirement investment portfolio. While there are many additional factors to take into account, hopefully, these few actionable insights can help you strengthen your portfolio, even if it's just a little bit.
On a final note, don't feel like you need to account for and implement all of these things at once. Otherwise, you run the risk of being overwhelmed and not implementing any of it. If needed, make small adjustments over time that coordinate well with your current situation.
So, that's it for today's show. If you have a minute and find this information actionable and insightful, please share the podcast directly with others you think may benefit using your podcast app. If you'd like to learn more about the rules and strategies discussed in today's show and you wanna find more information, you can find links to the resources we have provided in the show notes on your podcast app, or you can visit us at retiredishpodcast.com/seven.
You can also sign up for the monthly Retired-ish newsletter there as well, where each month, we discuss money and emotions, investing, tax, estate tips, Medicare and Social Security, and even a brief discussion about the current markets in layman's terms.
We always include something actionable in our newsletters so that you can implement right away, such as how-to guides and other simplified strategies. Again, this can all be found at retiredishpodcast.com/seven.
Thank you for tuning in and following along. See you next time on Retired-ish.
Securities and advisory services are offered through LPL Financial, a registered investment advisor, member FINRA, SIPC. The opinions voiced in this podcast are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA.
In addition, if you are required to take a required minimum distribution, RMD, in the year you convert, you must do so before converting to a Roth IRA. Investing involves risk, including the potential loss of principle. No investment strategy can guarantee a profit or protect against loss. Past performance is not a guarantee of future results.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, and bonds are subject to availability and change in price. Government bonds and treasury bills are guaranteed by the US government as to the timely payment of principal and interest, and if held to maturity, offer a fixed rate of return and fixed principal value.
Treasury inflation-protected securities, or TIPS, are subject to market risk and significant interest rate risk as their longer duration makes a more sensitive to price declines associated with higher interest rates. Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free, but other state and local taxes may apply. If sold prior to maturity, capital gain tax could apply.
Neither LPL Financial nor its registered representatives offer tax or legal advice. Always consult a qualified tax advisor for information as to how taxes may affect your particular situation.