The “science” of portfolio construction requires numerous fundamental principles. Long-term portfolios call for an orientation toward return or growth through proper diversification. Growth needs to be tempered so as to handle times of recession, deflation, and inflation. As described in the Harry Browne “Permanent Portfolio” one needs to prepare for the four stages of the market; prosperity, recession, inflation, and deflation. While we can find ETFs such as VTI to fill the long-term growth requirement and GTU as our inflation hedge, we also need to drill further into the diverse asset classes to examine the correlation percentages between the individual ETFs as well as their correlations based on the percentages held within the portfolio. It is not sufficient to just pile an array of ETFs or index funds together and call it a diversified portfolio.
While there are many sample portfolios to be found within the ITA Wealth Management blog, not all meet the requirements laid out in the first paragraph. Slowly, I’m making some course corrections. While Browne’s Permanent Portfolio has worked very well over the recent past, 50% of the portfolio generates little in the way of income. Gold and Cash do not provide the yield many investors prefer or need, particularly as they close in on retirement. We can protect against inflation by including TIP, VNQ, and RWX while at the same time increase yield. With interest rates about as low as they can go, bonds do not appear all that able to guard against deflation. Further, deflation does not appear to be the problem we face as investors, although there is no way to be sure so we will likely include some sort of bond combination in the New Portfolio (NP) under consideration. Watch for the NP to appear within the next two weeks.
The New Portfolio should satisfy the mathematical requirement of equity orientation and proper diversification. By proper diversification, each investment should be sufficiently large to contribute to the portfolio performance, while not so large as to matter too much. The portfolio should include both domestic and non-domestic or international holdings. The Browne portfolio lacks proper international diversification. To protect against financial crisis we will include U.S. Treasury instruments such as TLT and TIP. To hold down portfolio risk we may employ short or ultra-short equity securities at particular times. I expect this to be only in rare situations, but a sample can be included to show the power of including such risk reducing ETFs.
Readers need to keep in mind that there is no perfect portfolio, and even if there were, it would not suit everybody. If we can come up with an array of investments that have low or reasonable correlations, individuals can adjust the percentages to meet their personal requirements.