7 principles to help you create your perfect portfolio

A good place to start is a new book co-authored by Andrew Lo, a professor at the MIT Sloan School of Management, and Stephen Foerster, a professor at Western University’s Ivey Business School.

Titled “In Pursuit of the Perfect Portfolio,” 10 of the world’s most prominent figures in the finance world, including Harry Markowitz, Bill Sharpe, Myron Scholes, Bob Merton, Gene Fama, Jack Bogle and Charley Ellis, discuss with Lo and Foerster their idea of a perfect portfolio.

And what you’ll learn is this: There’s no consensus. There’s no one perfect portfolio. Ten experts. Ten different perfect portfolios.

There is, however, a perfect portfolio for you.

That’s right. What Lo learned from interviewing these brilliant minds about their contributions to the science of modern investing is this: “Each of them focused on a particular aspect of our financial lives — and we actually need all of them. We need as many different perspectives as we can get because we never know what circumstances we’ll be in and what particular ideas will be helpful.”

For instance, Bogle’s cost matters hypothesis (CMH) “benefits everybody, but that’s not enough” Lo said in an interview. “You need to think about investments differently in a bull market versus a bear market.”

And that’s what Robert Shiller, Jeremy Seigel, and Ellis point out. “Portfolios are highly personal,” said Lo. “It depends a lot on your personal circumstances, your personal tastes, your willingness to take risks. And what we’re seeing across these 10 luminaries is there are different approaches to dealing with those highly personalized issues. And I found something valuable in all of them.”

So, how might you go about creating your perfect portfolio no matter whether you’re saving for or already living in retirement?

Lo suggests using what he calls the “Three Ps of Investments.” The three Ps being principles, process and path.

But know this at the outset: Constructing your perfect portfolio won’t be easy. In fact, it will require a fair bit of introspection. “You’ll need to spend time thinking about all the different aspects of your life,” said Lo. “And it’s not just the financial aspects. That is probably the most important takeaway. We have to integrate the rest of our lives into our financial lives. You really need to bring into play your objectives, not just your financial objectives, but your overall objectives.”

And that, in essence, is the purpose of the three Ps. It’s to get you to “think more introspectively” about who you are and your financial needs.

The 7 investment principles

You would begin the process of creating your perfect portfolio with this checklist:

1. Determine how much expertise you have in financial planning and how much time and energy you’re willing to devote to managing your perfect portfolio. “The first principle is to start you thinking about whether you really want to try and do this yourself, or whether you need professional help,” said Lo.

2. Determine what your current and future financial needs are.

3. Find your comfort zone regarding financial gains and losses.

4. Think about your investment philosophy and what you believe about markets.

5. List all the assets that you have and the assets you are willing to hold, such as mutual funds, ETFs, stocks, bonds, real estate, and so on.

6. Develop a sense of the current investment environment and how stable that environment appears to be relative to historical norms.

7. Avoid obvious mistakes.

“All of the investment principles are designed to get us to think about how to construct that portfolio, that ideal portfolio,” said Lo. “To say to somebody that ‘you should invest for the long run’ sounds good but what does it really mean? And why do we believe that? And is that always the correct advice regardless of what’s going on in the market? The 10 giants of finance provide context for the advice they are giving.”

The process

The next step in your journey to creating your perfect portfolio would have you better understand who you are and where you are today by fitting you into one of 16 different investor archetypes. And those 16 archetypes depend on four key characteristics: your degree of risk aversion; the magnitude of your current and future wealth and earnings power; the magnitude of your current and future financial needs; and the investment environment.

Lo calls these the RISE criteria: risk, income, spending, and environment.

So, for instance, under risk, you might be a Hawk (risk-seeking) or a Dove (risk-averse). As for income, you might be a high-income Midas or a low-income Penia (the Greek goddess of poverty). Under spending, might be a Gatsby or a Scrooge, for instance. Under environment, you might fall under Expansion or Recession. All told, that results in 16 unique archetypes each of which leads you away from a one-size-fits-all portfolio to a more personalized one.

This exercise might seem a bit complicated. And that’s just the point. It is. “Financial management and financial planning are complicated,” said Lo.

Unless people appreciate the complexity, he said they are just going to think they can get an app and put their money in a Robinhood. “It’s not enough,” said Lo. “They actually need to get smarter because life has gotten more complicated.”

The path

The final step to creating a perfect portfolio is the path. And the path highlights four levers you have available to help in achieving your financial goals: the target size of your financial goals; how much you’re willing and able to regularly contribute by way of savings and investing; the length of time you have to achieve your goals; and the expected return of your savings and investing.

Ultimately, the path will tell you, for instance, whether your portfolio should be equity-dominated (more than 50%) or balanced (roughly equal in stocks and bonds), based on your willingness to take risk.

Know, too, that as you go through this exercise, the perfect portfolio is what’s best for you at the moment. “You never step in the same river twice,” said Lo. “You’re changing all the time. And so the way you get to where you are actually matters… We are all a product, not just our times, but our histories and experiences. So, you need to take into account both the previous path that got you to where you are, as well as the future path that you’re going to take in order to try to reach your goal. Life is path dependent and therefore investing has to be path dependent as well.”

So, what’s the perfect outcome for those who read the book? 

“We want to give readers not just the tools but the mental stamina to apply those tools and be able to do something with it,” said Lo.

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