How to Build your own Investment Portfolio – Part 1
In episode #76, we talk about how to build a portfolio that maximises expected return while minimising risk based on Modern Portfolio Theory. In our previous episodes, we’ve learnt about picking our own stocks, ETFs, REITs and bonds. So now the question is, how do you put all of them together in a way to maximise expected return and minimise risk? Or should you even try to do that? Tune in as we share some broad ideas Modern Portfolio Theory and give you three questions that will help you form the basis of building your own portfolio.
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Should you build your own portfolio, or more importantly, how do you go about doing it? I think over time, we’ve learned a lot of stuff, right. From picking your own stocks, picking your own ETFs, a little bit about REITs, a little bit about bonds here and there. And the question is, okay, now we know all these parts, how do we put all of them together? Should you even consider to build your own portfolio, right? So there are a lot of intricacies involved in this, and I’m not saying that I can cover everything for you, but I’m going to give you some broad ideas, right? So we’re going to run a two-part series to establish this idea of how do you go about building your own portfolio.
Firstly, I need you to know I’m not a professional and I’m not trying to give you professional advice, but this is how I do it. And in the first part we’re going to establish some terms, understanding the, you know, major ideas out there of how people go about doing it. And then the next part we’ll do it.
So welcome on board, this two-part series on building your own portfolio. I hope that at the end of the day, you can learn some stuff or at least be able to have a better idea of how do you go about doing this and pick your portfolio manager. Welcome home.
Good morning, everyone. I welcome you to another day with The Financial Coconut. In our podcast we will be debunking financial myths, discovering best financial practices and discussing financial strategies that fits our unique lives. You get it. Ultimately empowering us to create a life we love while managing our finances well. And today we’re going to spend some time in this first part to understand Modern Portfolio Theory: what is it trying to do, and some basic terminologies to get you warmed up before we’re going to part two next week to talk about how do you build your own portfolio.
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Woohoo, xiao excites huh. Today’s episode is a special one because I think a lot of people have been asking about this for a really long time. And, you know, I have been a little apprehensive to do it for a while because it is actually very difficult to really explain it beyond just throwing terms at you and for lack of a better way to put it, it’s very hard for most people to do this. So, you know, I was like, hm, do we really want to talk about this?
But over time I realized, okay, okay. I think our community is getting better and better. We learn all these little components over time, and now maybe it’s time to level up and talk about things a little bit more complicated, like building your own portfolio.
And if you have ever considered building your own portfolio, it shouldn’t be foreign for you to hear this theory called Modern Portfolio Theory, right. And most of the portfolios out there are built based on Modern Portfolio Theory. Even those that say they’re not based on Modern Portfolio Theory has elements of it, right. Which we will talk about it as we go along.
I am not saying that I’m like a strong believer of this theory, but it is the current standards, right? So in the market currently most portfolios are built this way. So let’s start here, right? Understanding this first, before we go into, you know, how do I interpret and how do other people interpret, you know, Modern Portfolio Theory.
So that’s the first thing we’re going to embark, alright. Just try to stay with me for the first few minutes, because inevitably, I need to talk about some mathematical ideologies and some terms, right. So I will try my very best to explain to you without having you tune off or faint la, huh.
So Modern Portfolio Theory was founded in the 1950s by this guy called Harry Markowitz. Honestly, I definitely butchered his name la, but that’s not the point, right. The point is what is he trying to do here in this theory? Right, so the central idea of MPT, Modern Portfolio Theory, is to try to create maximum expected returns possible with minimal amount of risk. Okay, so two major terms are maximum amount of expected returns, and minimal amount of the risk, right?
So we will go into this as we go along, but at this moment in time, you’ll be like, wah, really meh. Can like that meh? Sounds amazing, ah, promised land. The reality is it is a lot tougher to do it than the theory sounds la, right? Because there are a lot of assumptions as we go along, but without going into the technical details, there are some things that we need to talk about first before we dive deeper.
So base on MPT, okay. One of the things that you need to understand is that every tool has an historical expected return. Okay, this is what the theory assumes and is based off probability over a certain time period.
So let me give you an example. Let’s say in 10 years, okay. In 10 years, for the past 10 years, 9 years there’s this one investment that makes 10% a year. And there’s this one year that it made a loss of 30% .In other words, right, there’s a 90% chance of you making that 10% return in this 10 years time period, and 10% chance of you losing 30%. So when you weigh that risk out, the mathematical calculation is 0.9 times 0.1, right? 90% of 10% yield plus 0.1 times -0.3, 10% of 30% loss. Then you’ll bracket the whole thing and you multiply 100%. The average historical expected return, okay, is 6%.
Okay, so let me just give you another example. In another investment, okay. In 10 years, investment B in 10 years, 5 years, it makes 12% a year. And then the other 5 years, it made 3% a year. So 0.5 times 0.12, 50% chance of making 12% in 10 years; plus 0.5 times 0.03, 50% chance of making 3% in the other 5 years. And then you bracket the whole thing, times 100% is 7.5%. Right. So the historical expected return for the past 10 years is 7.5%. The idea is not to help you become a math pro la.
Anyway, if this one can become math pro, math pro also a bit cute la. But anyway, the idea is to understand historical expected returns first. Right? It’s very easy to find. You can just go, you know, Google historical expected return of S&P 500 or historical expected return of Straits Times Index, whatever index that you are trying to find, someone has already did their calculation, right. So that is the historical expected return, number one thing that is very crucial in a Modern Portfolio Theory, because they want to find out what is the chances of making this amount over an expected time period. So historical means all the way since they have tracked, all the way til now, weighted across the probability la.
And in other words, it means that we are trying to find an average potential yield of this particular investment across the whole time period, right? So that means at any one time that you buy the highest possibility of you attaining is, let’s say in investment B, 7.5% in that year. Probability weighted mah.
Of course it does not mean that it definitely will happen. You may be just nice sui sui, you buy this year, next year lose, but if you hold it out for a longer term period, you will average out to be about 7.5%. That’s what it’s trying to tell you, ah, average potential yield.
And the next thing that you need to understand in MPT is this idea called standard deviation, right?It’s a very statistical term. In other words, it is trying to find out how much volatility and how much variance this thing has. If this year it makes 30%, next year, it makes 10%, next year it loses 50%, wah, the movement is very big, right? So there’s a lot of fluctuations, very big fluctuations, right?
If every year it makes 3%, 4%, 3%, 4%. Then the volatility is very low. The standard deviation is very low, right. The variance is very low. Of course, a lot of people use standard deviation, volatility, variance very interchangeable, but technical terms, they have differences. The idea is to try to find things with as limited fluctuations as possible.
Why? Because based on MPT, there is an association with higher volatility to higher risks. The more the portfolio moves this year, higher, next year, very, very low. Up, down, up, down like that, then it associates it as very risky because very volatile, right. Because of course, I know risk to many people are different, but in this theory, risk is volatility, the higher the volatility, the higher the risk.
So in the pursuit of MPT, Modern Portfolio Theory, they are trying to get the most amount of yield, highest maximum expected return to the lowest volatility, right? Most number of potential yield to the lowest volatility, which is the lowest risk. So okay ah, you get an idea, yeah. Essentially that is what it is.
And in the process of constructing a portfolio through this theory, there’s this other term called correlation, which we will talk about it next week. Okay, I don’t want you to go crazy first. You just need to understand these two things first, yeah. Highest expected return and the concept of volatility associated to risk. Correlation, we talk about next week.
Okay, so that is the brief idea of MPT, Modern Portfolio Theory. Of course, we can go into the mathematical calculation, statistical calculation, but those things are not important for us, right. We are just layman retail investors. More importantly, it’s now that we have recognized the MPT is the common knowledge out there, it’s a benchmark for a modern day portfolio creation, then how do we actually do it for ourselves, if we don’t want to participate in too complex strategies using, you know, all your, synthetic, your derivatives, your, you know, all these different tools that are a lot more complicated. How do we then do it for ourselves? Right? Because we are not professionals la.
We’re just retail guys trying to make a little bit more money. Or at least know what’s going on so that we can pick the right guys that we are trying to, you know, work with. So in the later part of this episode, I’m going to spend some time to throw out some basic ideological questions for you. Three basic ideological questions for you when creating a portfolio.
And in this process, I’m going to try to address some of these pointers within MPT and maybe some of these pointers that I see different from how MPT does it.
Okay. Much like many other theories out there, it is always mathematically calculated and scientifically backed, right? So it is a, for lack of a better way to put it, very neat. There are a lot of assumptions involved, things like historical yield, things like assuming volatility to risk, you know, things like finding a correlation and, you know, a lack of correlation with different different tools, which we will talk about next week. But the idea is because it is too neatly put together, I think a lot of times it does not really recognize real life, right. Because yeah la, it’s a mathematical formula mah.
So ultimately you got to take these theories — the theories have basis, okay. They’re not baseless. Some people just conveniently throw these things out, but I don’t think it is fair to put it that way, because reality is when you diversify, you’re already subscribing to some essence of modern portfolio theory, because you are buying different tools to try to, you know, dampen the volatility.
Because if you assume the share market to be the highest, most volatile thing, then you buy all these other things, you’re trying to reduce the volatility mah, for lack of a better way to put it. And yeah, MPT is, is what it is la, but all that being said, what are some questions that you probably need to have to begin building your own portfolio?
Number one question. Okay. How long is your investment horizon? In other words, when will you start eating from your investments? Okay, a lot of people say how long, how long, but they never indicate what does it mean by how long. The reality is when you start eating into your investments, that means you no longer have active income.
And you’re starting to draw down from your investments. That is where you need to really be concerned about, you know, balancing your portfolio, generating cash, and focusing on more like cash generation, more dividend based kind of stuff, rather than trying to accumulate capital gains through the volatile stock market.
Which brings us back to MPT. Right? So under MPT, you realize that the measurement of risk is based off volatility, right? So since everybody is trying to, you know, build lower volatile staff, right. They will always add on other things to kind of dampen that volatility so that, you know, there’s a reduced assumed risk.
All right. So from a portfolio perspective, it may be true, but, you know, is that what we really want? Is that who we are at this moment in time, right. But why is this important to understand, okay? To dampen volatility in a portfolio, right, it is very expensive. Okay, first you can lose out on opportunity costs. From opportunity cost angle, because if the stocks are making 10% a year on average, then because of volatility of stocks seem to be one of the highest and you want to reduce the volatility so that you reduce risk by MPT’s idea, you shift 30% of your total portfolio to something like a fixed income bonds, which pays you about 2% a year.
With a much lower volatility of course, because they are fixed income bonds mah, they pay you a fixed output every year, right. And in that sense, you immediately dampen the volatility already. Because it’s a relative standpoint compared to 100% in the stock market. Now you’re 70% in the stock market, 30% fixed income bonds, pay you lesser, but definitely is less volatile, right.
Because for lack of a better way to put it fixed income bonds are way less volatile. Right. And yeah. Things we have like variance and beta and all those things very complex. If you want to understand more, we can talk about it another time, but all those things are not as important yet. The idea here is you are sacrificing potential returns of 10% a year to be 7.6%, okay, highest expected historical return , for the sake of reducing volatility in your portfolio. Right? And it definitely reduces the volatility with reduced risk, but like, do you really need it at this moment in time? That is something you need to ask yourself. Of course, there are many other ways to divert these risks: options, derivatives, insurance, et cetera, et cetera, not important.
The idea is because it is so expensive to participate in the MPT style kind of portfolio, do you need it now-now, right? Because most people, when they participate in this kind of portfolio construction, they are just trying to reduce market fluctuation using other investment tools. And you know, if your runway is very, very far ahead, you still have 20-30 years, then do you really care about these kinds of reducing of fluctuations?
Is it important to you? Of course, you know, picking your own stocks using ETFs, whether is it, you know, you invest in US, China, Japan, Singapore, whatever emerging markets, right, all those are ongoing discussions that we can talk about in terms of the stock market, you know, but, you know, you can go to episode 36, 54, aiya, we got a lot of investment related stuff.
But the central question now is, do you need it now now? So my view is for most people you probably should participate in MPT-style kind of portfolio slightly later in your forties or fifties. Okay, especially for me la, I will do that. If let’s say I were to continue down this narrative of working and working, then I will probably start to engineer an MPT portfolio in my forties and fifties.
Why? Because that is a period of time when I start to experience increased risk of being pricing out of the labor market. That means people don’t want my skills already. My skills are passe already, no use. Right? So I got insufficient active income to continue to compound, or, you know, maybe even meet my expenses, just so happen my expenses keep climbing over time. Then there is a reason for me to really look into like building portfolios like that, you know, which is like less volatile, more predictable. So then I can then eat from it. But I just want to caution you this idea that your financials are not just your investments. You have your insurance, you have, you know, your savings and all these other elements, right?
So if you already hedge, you have savings three years to hedge. You have insurance to hedge against, you know, financial black holes because of medical situations or whatever fire or something. Then why do you still need to further hedge more, you know, from a portfolio standpoint, if you are not planning to eat it any time soon? Because it’s expensive to participate in this kind of portfolio styles, right.
But of course, once you are eating into your portfolio, then there’s a different story. Then we have to create more predictable income through those portfolios. Which brings me to my second question that you need to ask yourself when building your own portfolio is: how much fluctuations can you handle from a worst case scenario?
The thing about, you know, MPT, alright, I keep using it because that is the benchmark today right. It’s that they try very hard to just kind of perform always the same. So they’re very focused on trying to create the mean forever and ever, so that whatever season it’s the same, or supposedly that’s what they’re trying to do la.
But if you think about it, life is not one case, right? It’s always seasons or things are always changing. So if you can be nimble with your lifestyle, knowing what are your survival needs, your creativity needs, your thriving needs, all those different stuff, then you won’t really need to be so uptight about always performing a line. And in that sense, by doing that sacrificing some potential upside gains. But that is from an investment returns, very strategic, point of view.
This question number two is a very psychological question point of view, right? Because if the market fluctuates, right, which it will happen unless we change this whole capitalistic system, assuming this thing repeats itself, then every 10 years there’ll be a dip, right? And I think for past 100 years, the worst dip so far in the US market is about 60%, all right. So worst case scenario is down 60%. Can you handle 60% for a few years, 60% drop in your portfolio for a few years, or do you have extra capital that you can then double down in to then ride through this downtime?
But if you psychologically cannot handle a 60% drop, okay, you won’t know until you really handle it. So 2019, 2020 gave you some insights into like, what is the worst shit that can happen from a psychological standpoint. Can you sleep or not? So if you cannot handle 60% and a few things, one thing, you’d probably get someone else to manage your money, ’cause I think you don’t understand investments enough, or you don’t have the kind of emotional rigor to be in the market.
And the other thing is you can always, instead of putting a hundred percent in the stock market, which will render you a 60% dip in your portfolio, you can put 50% in a stock market. And then that will render you lowest dip of 30% in your overall portfolio. So you already cut that by half, just because you’ve put half your money in the stock market, half your money not in the stock market.
So then overall portfolio will not dip by 60%. It will only dip by 30% just by pure, you know, percentage wise. And I actually started with all stocks, 100% in the stock market. And over time, I think maybe I’m getting older, maybe I have a little bit more so that I want to put it in different places and or maybe I kena influenced by all this MPT stuff that I feel like, yeah, maybe I should, you know, buy a little bit of other stuff, which I think we’ve talked about it in a earlier episode this month, I’m building a REITs portfolio. If you haven’t checked it out, you should check it out.
And I also own a little bit of gold in my portfolio, but that’s about it, right. And over time I will keep tweaking and keep adjusting. But, at this moment in time it’s still like predominantly in the stock market, which brings me to point number three of questions to ask yourself building your own portfolio. And that is: what are the tools that you actually understand?
So if you understand what is going on, essentially all these managers are trying to build a broadly diversified portfolio. That is the marketing term, broadly diversified portfolio.
Okay. But when they go to their office in the back end, right, they will have all these other measurements as to how much the movement of stock market affect the bond market, how much they affect property, how much they affect gold. And they have, let’s say, maybe these days they will have crypto or maybe, you know, all these different things that they will all the different baskets of investment tools out there that they will then pick and choose to build a particular portfolio that meets your needs, all right.
So same idea, maximum gain, lowest volatility, assuming lowest risk. Okay. But these are professional guys, you know, then even they are going nuts and they are being driven into things like art la, wine la, cheese la, venture cap , you know, watches and whatnot, all right. So all the collectibles and alternative investments. But all those things don’t matter exactly matter if you are trying to do it on your own, because fundamentally they probably have a better idea why do they buy these things. But for most people, right, they really only buy it off some like random correlation observation.
What do I mean, okay, what do I mean? Things like how people put some money in bonds, right. Just so because they believe that it runs inverse to the stock market. So it is a good balancer and a dampener, you know, for volatility right? And do you really know how bonds work? You don’t know how bonds work, you know it’s inversely correlated based on historical data to the stock market, but you don’t know how the bond markets work.
You don’t know what you’re doing. You don’t know why you’re buying. So when you build your own thing, just because of this correlation out there, that stocks move inverse to bonds, then what are you actually buying? To put it in a very real example, like let’s say, every day you wake up and then you go get ready to go to work or go to school and you exit into your corridor and you see your plants grow and grow and grow.
And you think like, wow, my plants keep growing ah. I don’t need to do anything. I just sleep and wake up. That’s it. But actually your mom has been watering it every day, add fertilizer every week, but you don’t know. You just observe that everyday when you wake up your plants grow and you draw the conclusion that, oh, the growth of the plant is correlated to how many good nights of sleep I have.
So that is a very big problem in my view, right? When you assume correlation without understanding what you’re actually investing in. So I’m not against broadly diversified portfolios. I’m not even against MPT. I think those are theories, they form the basis of is going on and they have their own logic, which is fine.
My biggest problem with most people is that they invest into things just because they want to subscribe to this broadly diversified portfolio, but they don’t actually understand what they are buying, right. So you can invest in bonds, yes. But how much do you know about bonds, bond fund? How do credit ratings run?
And you can invest in properties, but how much do you actually understand about the property market? So at some point in time, you need to ask yourself, okay. If I understand this thing, I’ll buy a little bit of it. If I don’t really understand, I can buy very, very, very small part of it and keep learning until I feel comfortable enough to know what I’m doing, which essentially means you can explain to the person next door, this is what’s going on. And that’s good enough.
I don’t think you need to write a thesis and whatnot to prove that, you know, what’s going on, but you get the idea right. Only invest in what you understand, that is what I believe in, right? So these three questions will help you to form the basis of building your own portfolio.
I’m going to recap ah. And number one question is how long is your investment horizon? In other words, when will you start eating from your investments? Okay, if you have 30 years to go, 30, 40 years to go then, okay, you may not need to participate in an MPT style portfolio.
Number two is how much, you know, from a worst case scenario, can you handle? How much fluctuations can you handle? If going down by 30% is okay, going down by 50% is not so okay then, yeah. Maybe we can take that as the worst case scenario and build your own portfolio.
And number three is what are the tools that you actually understand? For me, it’s really about learning as we go along and buy things that you understand. Don’t just randomly buy it because you know, there’s some sort of correlation of there. Someone else say something, right? So learn and learn and over time you will figure something out that will fit your own pallette. I hope you learned something useful today.
This is part one of our two-part series of building a portfolio on your own. Part two we will talk more about the step by step. And I’ll show you a little bit more about correlation so that you understand what is going on in the process of building your own portfolio. So I hope you learned to useful today. See ya!
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Okay. So today is only the start, you know, of how do you go about building your own portfolio. Or how do I plan to go about building my own portfolio. This is not advice, okay. Education and entertainment purposes only, very important, all right. So more importantly, it’s for you to learn some basics and we’ll continue next week.
It’s going to be really fun and very interesting. I love these two episodes, by the way. And later this week, later this week, we’re going to have a friend of mine to come on to talk about bonds. And it is something that people don’t really talk about as much. It’s always like, okay, we need to get some stocks and bonds, but how do you go about picking your bonds? You don’t really know, right? How do you evaluate bond funds? How do bonds actually make money? Can you actually make money in a negative bond environment? Nobody really knows. Other than the pros la, right. So we’re going to get the pro on.
So this week, see you all with Money Owl, Chuin Ting will come on to share with us very good insights. And she has a lot of good lessons because she was in the heat of the 2008 financial crisis. So all the good juices are going to come on. So we’ll see you later this week. And so for next week, it will be a continuation of today’s episode, right. There will be part two.
And for everyone else that is, you know, Chinese and celebrating your new year, that’d be great, happy new year to you. For everyone else, happy holidays, go out and have fun and I will see you guys next week. Bye bye.
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