Ep 77: How to Build your own Investment Portfolio – Part 2

Before we begin, I want you to know that everything discussed today is for education and entertainment purposes only. Please do not take this as any form of advice. If you need financial help, please seek a licensed financial planner.

Okay. So in part one, we took some time to understand a little bit more about Modern Portfolio Theory, which is the convention today. And within it one of the things we talk about is historical expected return, right? How do you measure that? Essentially it is a weightage, right? You weigh across the probability of something happening. And fundamentally it is just trying to help you to understand what is the average possibility of yield from this particular investment over a period of time, right? Based on all the cases happening. If you want to get a little more detail, you can either Google search or listen to part one. 

And we’ve also talked about this other concept, which is higher volatility equals to higher risk. And that is the central idea behind Modern Portfolio Theory, which on some level you can understand, right? Because if something is very not consistent, not predictable, then it is relatively risky in trying to achieve the yield that you’re trying to get, right. So usually measured in standard deviation. And you know, all this very statistical la. So you can either Google search or you can listen to part one. I will not go deeper into this thing. 

But what you need to understand is under MPT, the goal is to get maximum amount of yield with minimum risk and minimum risk is minimum volatility. Then the next question is, how do we go about achieving that, right? And we had to bring in this idea of correlation, which is what we’re going to talk about today to begin with. Before we go into the how, we need to understand this concept of correlation. Correlation is actually a very mathematical  idea also, right? So if you want to really find out how to calculate some thing’s correlation with another thing, you can always go and search on Google, right? Correlation coefficient. 

But without going into the technicalities of trying to achieve that mathematical excellence and formulae, we will just talk a little bit about the idea. Okay. What correlation coefficient is trying to find out essentially is how much something moves with reference to the other thing. And in the measurement of this relationship, right, there are three numbers you need to look out for: 1, 0,  and -1. 

So if let’s say something has a correlation coefficient of zero, that means these two things have no relationship at all. Much like today, if you wake up early in the morning and then you, either you exit your bed from the left or from the right, it is not going to affect the auntie downstairs, whether is she going to be happy when she cook her bak cho mi, you know, that’s the idea, right? They have no relationship at all. 

If somehow, if you wake up on the left, the auntie downstairs, make bak cho mi nicer, you tell me, okay, you tell me, ah. I go look for that aunty. [Laughs] But the idea is that these two things have no relationship at all. The movement of A does not affect the movement of B at all. 

And if we translate that into the financial markets, right, with reference to the stock market, most people, they build things with reference to the stock market. Okay, we’ll talk about that later.

But so with reference to the stock market. Let’s say, A, the stock market moves, okay. If the prices of the stock market move and B doesn’t look like there’s some sort of relationship involved yet. That means the movement of A does not affect the price movement of B. Then you can say that they have no relationship, okay. Something like maybe the papaya tree downstairs.

Okay, papaya tree is an asset, right. It gives you fruits every season and you can take the fruit and go and sell, however you want to do it, right. But the price movement of the stock market does not affect the price of the papaya tree downstairs, okay. You get an idea. It may la, okay. But if let’s say it does not, then it is said to have zero correlation at all. So the coefficient is 0. 

So then there’s this other number that you need to look out for when you’re looking at correlation coefficient. That is 1. Okay. And  what is 1? 1 means they have perfect linear relationship. They should perform the same. So something that should perform the same in a stock market is the index fund.

The index ETF should perform the same as the index. So if the index move up by 1, the index ETF should move up by 1. Their relationship should be linear. If their relationship is not linear, which, you know, we have talked about this in the part of choosing ETF, episode 30, then there is a tracking error. Then this is a problem with the ETF. That means the  ETF is not doing its job trying to track the index. 

Of course, there’s this other number which is called -1. Okay. And this shows that there’s an inverse relationship between A and B. So let’s say if the stock market moves up and you know, this other thing goes the other direction all the time, that means they have a perfect inverse relationship, right. And something like maybe an inverse ETF lor. Every time this thing goes up, the other thing will come down, definitely. Something like that.  

So 1 and -1, they are the extreme. Everything in between forms the spectrum of relationship, the higher the coefficient, that means the closer these two things are related. They have a linear relationship, okay. Their movement is very predictable and they move in a similar direction. And if something is inverse, they have a close to -1, then they are moving in a separate direction. 

Okay. So I hope you are still around, still with me, you get the general idea why correlation coefficient is very important in trying to figure out the relationship between different assets.

That is not to say that everybody has to become a statistician and start trying to go and find out what’s the relationship between different, different asset class. But for a lot of people that are building portfolios in a professional manner, they always look at this thing because they need to understand how much is this other tool with reference to the stock market.

Which brings me to point number one when you’re trying to build your own portfolio and that is: start with stocks. Okay, whether you are going to pick your own stocks or ETF, it does not matter, but you need to get access to the stock market. And yes, I just want to, you know, reaffirm that this is for education, entertainment purposes only. But I’m very passionate about the stock market. I’m going to give you a reason why. 

Okay, but don’t take this as any form of advice. Please go and seek your professional financial planner. Conventional wisdom today says that over the past hundred years, the stock market has been a consistent one, you know, with the highest historical expected returns, for lack of a better way to put it. And I will conveniently strike off crypto today because they don’t really have a track record. I know everybody will be like, eh crypto make a lot of money, it’s like okay, I don’t, I don’t know. And we’ll see how things goes as we go along. And I will also strike off special cases that requires like expert knowledge. So say if you flip properties full time or you pick and trade, you know, private companies in a VC fund or whatever special thing that you do that other people cannot replicate. So it requires a special expertise then, you know, I will conveniently strike those things off. 

Assuming you’re average individual like myself, and you want to build your own portfolio, I think the stock market provides a very consistent historical returns so far. And assuming you are in your thirties. Okay, let’s say 25 to 30, since most of you guys are here, and you’re not going to eat into your portfolio anytime soon. 

Like question number one from last week, how long is your investment horizon? So if your  investment horizon is about 20 years out, right, you can have the time to compound your portfolio. And that is what you want to do rather than, you know, broadly diversify it straight away.

Then you probably want to start with stocks because they have the most rigorous returns over time la. Which is why people always talk about index funds outperforming managed portfolios, but that’s a discussion for another day. The idea is the stock market tends to be the most consistent return over a long period of time.

The problem with a lot of people when they look at the stock market is they’re worried about fluctuations. Of course, there’s this other bunch of people that’s just gambling in the stock market la, I will not talk about them, okay. So assuming you’re going to start with stocks, right. And you have a extended horizon, an extended timeline to invest, then the other question that we’ve talked about last week is, you know, what is your risk appetite? What’s the craziest that you think you can go down, right? So that you still can sleep la, right. 

And historically for the past hundred years, in US the worst, it’s about 60% decline, okay. And most of them will last about three years. On average, the worst last about three years in terms of economic downturn.

So if let’s say you cannot handle a 60% decline at its worst, there maybe you can handle a 30% decline. If you can handle a 30% decline then your total capital, you put 50% into the stock market first. Also, yes, you can also DCA and all those kinds of stuff. Not an issue. Those are just strategies. You know, it’s open for discussion on how to refine your strategies.

But what I’m saying is your predominant part of your portfolio should start with stocks because they provide you the most returns and you have a longer time horizon than, you know, if let’s say you’re in your fifties or sixties. 

And actually if you’re in your fifties, your biggest risk is probably losing active income. Your time horizon is shortening, right? You’re nearing the time where you possibly will take on life, eating your own investment returns, which is fine, inevitable. So by then when you’re closer to your fifties then okay, yeah, I think it’s really a good time to start to look at cashflow generation, look at MPT style portfolios to sell down your equity and just do other things.

But I know everybody has something to say, okay, I’m not saying that I am speaking the absolute truth with a big T. Everybody has their own view, but to me, you start with stocks. And because we are young, we have a longer time horizon. That’s where we start most consistent, reliable, highest capital return over extended period of time without being an expert in something.

Which brings me to point number two, and that is to buy assets that you’re familiar with, that have low correlation to the stock market over time. So following the MPT idea, which, you know, its goal is to get the most yield for the minimal amount of risks, which has minimal volatility, right?

You inevitably have to buy assets that have low correlation to the stock market. Which is why we spent so much time in front to talk about low correlation or about correlation, right? Of course the professionals, they have much more complicated models with variance, covariance, and how different different tools affect each other. And they try to optimize the whole process. Those are complicated models, you know, I’m not fit to tell you how it’s done. And I don’t think most people will be able to do something like that if they are just like retail investors, trying to build their own portfolio, right. 

Eventually you may not want to build your own. You may just be learning, but if so happen you want to build, I think after starting with stocks as the base, you want to look to buy assets that have low correlation to the stock market because eventually in the idea of trying to build an MPT style portfolio or even a broadly diversified portfolio, you’re essentially trying to dampen the volatility of the stock market, right?

Because stock market has most yield, but most volatile, so you’re trying to dampen. And in order to dampen, you’ve got to find things that have limited correlation to the stock market, because if the correlation to the stock market is very high, that means the movement of the stock market will directly affect the movement of these other asset class.

Then it doesn’t really dampen that volatility that much. It is a statistical exercise to try to find the correlation between different asset classes. And you don’t really need to do that. If you want to do that, it’s fine. It’s yours. You know, I can’t help you with that. 

But if so happen you don’t want to do that, you can actually go and Google search “asset class correlation map.” It will send you to Guggenheim investments and they have a correlation map to tell you, you know, what is the movement of various asset classes with reference to the S&P 500. So that’s a good place to start. So I repeat go to Google and search “asset class correlation map,” go to Guggenheim investments, which is one of the largest investment company in world. And they actually have a map that they put it out openly. 

So, if you click into the map, you can see that the S&P 500 has a 0.97 correlation with global stock index, which, you know, in this case, it’s MSCI World Index, which means if the S&P 500 moves up, the global stock index will move along with it, to similar  impact also. And you know, that is not what we want la, because you know, we are trying to buy things that have a low correlation with the stock market. And if you  see the S&P 500 has a 0.22 inverse correlation index with the investment grade bonds, it seems like, okay mah, got some inverse relationship, right.

But actually 0.2 is kind of AKA not much difference la, that means it’s not very impactful, right? So from a grand scheme of a portfolio, most portfolios will overweight, will hold more bonds to counter the fluctuation because you know, the, the investor relationship is only 0.22. But of course there are a lot more, you know, complex asset classes that are not here, but I think this page rightfully kind of point out why there’s a search for asset classes that have limited correlation and it’s a good place to start. And for me, I started with 100% stocks, right. As you guys know by now, and over time, I bought a little bit of gold, about 5%.

I bought a little bit REITs at this point in time, about 10% SG REITs. And yeah, I’m going to compound and keep growing all these asset classes to have limited correlation, or lesser and lesser correlation to the stock market. In my efforts to try to build a lower volatile portfolio that can continue to pay me very good money while you know, even doing bad times.

But I didn’t start at one goal, right? So start with stocks. Over time I keep learning new things and you know, these days I’m trying to learn about bonds. You know, I’m talking to all these friends and experts, you will hear from them soon, you know, and if you have any people that you want to hear from, definitely drop us an email to hello@thefinancialcoconut.com.

But the idea is after you start with stocks, you continue to learn about other asset classes that have a low correlation, and you know, you just kind of compound that over time. Over time, you keep buying and buying and buying all these other stuff. And somehow 10, 20 years later, you will have a broadly diversified portfolio.

And, you know, while it will not be like super optimized, which is what a lot of the professionals want to do, everything must maximize, optimal, maximum profit, minimal risk, you know. While it will not be like that — because you don’t really, you know, look into things like covariance, you know, all these other more complex modeling stuff — but if you do this, you know, generally it will be a lot better than just owning 100% stock. If you are trying to damper volatility la. 

So, yes, it is not about, you know, definitely finding the exact correlation of these different tools and, you know, have this ultimate model or formula. Another hack that you probably can do is that you can mimic some of the big boys. This is how they do it. Like you look at Dalio’s portfolio, right? He’s very famous for the all-weather portfolio, which is very MPT and broadly diversified. It’s about 30% in stocks 15% in commodities, 55% in fixed income. 

Fixed income will be like bonds, treasuries, those kind of stuff. And of course there’s no hard and fast, but yeah, he’s famous for what it is. There are other people that build all-weather portfolios, but that’s the idea, right? Start with stock market, number one, and then try to build all these other things.

As you go along, you learn new tools and you recognize that they have limited correlation with the stock market and they sit with the MPT idea. Then over time, you can just keep adding, adding, adding, and in due time you will reach a portfolio that, yeah, broadly diversified and shares this theory lor. In some ways, like in essence, at least, although you don’t know exactly what is the coefficient behind. 

Which brings me to point number three of building your own portfolio. And that is, I actually just need sufficient cashflow to meet my expenses by the time I’m 50 or 60. And then I’m very good to go already, right. So I don’t need to maximize my portfolio. I think a lot of people have this idea of maximization. Everything must be like a perfecto, right? Maximum yield, minimum risk, limited correlation, blah, blah, blah. Everything must be like optimization. 

And for the professionals, it is their profession, right? It’s like you tell the dancer, don’t dance the most beautiful, it’s quite weird. But you’re not a dancer. You can dance, good enough. So if you are looking to build your own portfolio, because you don’t trust any portfolio managers out there, or you are trying to understand a little bit more so that you can pick your portfolio manager, then what you need to understand is a lot more about what do you want, what do you need rather than the absolute best practice? Or try to maximize with some statistical backend. So this then comes in with a very interesting idea of having your investment income cover your expenses, which is what a lot of people are trying to like participate in, right?

The whole idea of a passive income, right. Have all this income so that you don’t need to work and whatnot, okay. By the time you’re 60, actually, it’s not about you don’t need to work la. It’s about does anybody want you or not, that’s another  question, but okay, that one, you know, no insult to senior citizens or pioneer generation. 

But the idea is eventually we all will get priced out of the labor market. So if we can get some sort of capital and keep us going, then we will be very good to go in terms of our own portfolio over time. And there is no right or wrong way to do it. Once you can generate a portfolio that create sufficient income to be able to meet your expenses, then you are good to go.

But if let’s say you are going to go down the common narrative of working and then retiring, then by 50, 60, if you can hit it, then it’s very good already. You don’t need to optimize and try to, you know, everything be like very sui sui, like trying to build the perfect thing. Right? What do you need? That’s the question.

So now I have a lot of stocks and I’m trying to build these other tools that I’ve picked up over time. And eventually I foresee myself to slowly sell down these kind of capital gains pursuit to go into more fixed and more stable cashflow-generating assets to just kind of help me tide through whatever needs I need as I go along.

So if you think about it at the end of the day, our goal is really to create a life we love while managing our finances well, right? It’s not about, you know, getting a lot, a lot, lot, house bigger and bigger and bigger and bigger, right? So ultimately it is what it is. And of course there are all these other things that you can consider, whether it’s from your CPF or HDB or insurance.

I choose to kind of leave them out of the discussion because it just makes the discussion very complicated. But if you’re trying to build your own portfolio after understanding MPT from part one, understanding correlation today, and understanding the three basic questions that I’ve asked last week, about how long is the investment horizon? What is the worst you can get? And what kind of tools you actually understand? 

Today I have established three points. I’m going to sum up. The three points is when you’re trying to build your portfolio, when you’re starting out after you know all the things before. 

Point number one is to start with stocks. You start with stocks, whether you pick your own stocks or ETFs, that’s up to you because stocks has been proven to be the outperformer over time. They perform the best la compared to any other investment tool out there, assuming you are not an expert in any particular thing. 

Number two is to buy other tools that you’re familiar with over time, right? You don’t need to know everything at one go, but over time you will learn new things. Pick up new tools. So based on what you understand and based on the time horizon that you have, you can slowly add on extra things, extra things, extra things. Eventually you will reach a broadly diversified portfolio. You don’t need to be in a hurry to learn everything at one go. 

And number three is to ask yourself, how much do you actually need lor. As long as you generate sufficient cash flow to meet your expenses by the time you’re 50 or 60, I think you are very, very good to go. Don’t need to be too hard up about portfolio maximization, trying to get the most out of things, right. It is good to have if you can do that. But if you cannot as an enthusiast or someone that is just very concerned about building your own portfolio, then why not just go for something that is good enough for you?

So I hope you learned something useful today. See ya.

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Okay. This is the end of two-part series. I hope you learned interesting stuff and get a better idea of how do you kind of piece all these things together. Ultimately it is your call and you got to you know, make your own decisions. Or look for professionals to help you with this process of building your own portfolio.

But either way, I believe in learning good stuff and just kind of have a basis to go about choosing  your professional manager that you seek for. A lot of times they are very sales-trained and they don’t know as much about managing portfolios. So I hope this is a good basis to help you.

And later this week, we’re gonna have some fun and we’re going to bring on a friend to come on to talk about Bitcoin, right? So Bitcoin is the hot topic. And I think a lot of people are considering to put it into your investments, but this guy, Arthur from DeFiance capital, has a very interesting thought about Bitcoin, because as much as he’s an enthusiasm of blockchain and cryptocurrency, he actually thinks Bitcoin may not be that resilient from a value standpoint.

So, yeah. Next week or later this week, right, we’re going to have him on to chat more. So stay tuned, have fun. And next week we’re going to focus on a book review again. So we’re gonna do one more book review, just kinda test it out and see if it works. Do let us know if you like it.

And yeah, it’s going to be this book called Atomic Habits. Everybody knows this book, very popular. And we’re going to share with you our perspectives. Much like you compound your finances in a market, compounding  your habits is also a very important part, all right. So next week there’ll be book review, later this week we’re gonna get Arthur and yeah, my God, so much content. I don’t know what to say anymore. So everyone else having a new year, happy new year, everyone else, happy holiday. And we’ll see you later this week. Bye bye!