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What Does an Investment Portfolio Need?

I recently encountered a conversation about the characteristics of a good portfolio. The person speaking (whom I didn’t know) had a long list, but it got me thinking about what I would include on such a list.

I came up with only three things. (That is, only three characteristics that make a portfolio strictly better than a portfolio that does not have those characteristics.)

  1. Diversification,
  2. Low costs (including tax costs, if applicable), and
  3. An appropriate overall level of risk.

With regard to diversification, the most critical thing is diversification among individual holdings (unless we’re talking about FDIC-insured CDs or Treasury bonds, for which diversification isn’t needed). Point being: Don’t set yourself up for financial catastrophe if a single company goes out of business. Also helpful, but less important, is diversification among asset classes — have some stocks and some fixed-income.

With regard to costs, the lower you can get the better. But it’s important to think in dollars rather than proportions. For instance, the difference between an expense ratio of 0.8% and an expense ratio of 0.2% is much greater than the difference between 0.2% and 0.05%, even though in each case the less expensive option is 1/4 as costly as the more expensive option. On a number of occasions I’ve heard from people considering changing fund companies in order to shave just a few hundredths of a percent off their average expense ratio. It would be rare for such a change to be worth the hassle for anything other than a very large portfolio.

When it comes to choosing an appropriate level of risk, it’s important to know that this is a very rough thing. Your risk tolerance isn’t something that can be measured precisely. In addition, your risk tolerance will change over time. (And the riskiness of different combinations of investments changes over time too!) Finding something that feels “approximately right” for you is as good as you’re ever going to get here.

The reason I’m such a big fan of index funds (and/or ETFs) is that, in most cases, it’s easier to achieve each of the three goals above by using index funds. Index funds are typically very well diversified, with very low costs. And it’s easy to achieve any particular level of risk with index funds. But the above goals certainly can be achieved with actively managed funds. Vanguard, for instance, has a long list of actively managed funds with super low costs.

For many investors — myself included — “simplicity” would also be on the list of characteristics that improve a portfolio. And simplicity is also aided by the use of index funds or ETFs. But I’ve left it off the list because some people truly do not care about it. They’re perfectly happy to manage portfolios with 10 different funds across several different accounts. And there’s nothing wrong with that.

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