Portfolio Construction – Part 1

Welcome to our guide on portfolio construction!

Possibly one of the most difficult tasks you will be given as an investor is constructing your own portfolio. There are a multitude of factors that come into play, probably more than you’re even thinking about right now.

In order for an investment portfolio to be successful, it simply cannot afford to ignore any of the key elements. We are going to discuss a few of those key elements in this guide.

Part 1 – Define Your Goals, And Your Nest Egg Amount

In order to properly invest, a person needs to know what they are investing for. More often than not, the answer will be retirement. But this isn’t always the case. Some may be investing to have enough to place a down payment on a house in 5 years, or to start a new business.

After you’ve decided what your goals are, the next step is to actually figure out how much you’ll need. The old adage of “you need $1 million to retire” doesn’t apply anymore, especially to younger generations. The purchasing power of $1 million was actually quite significant when this baseline of retirement was initially accepted. Today, the purchasing power of $1 million is much lower, and by the time a millennial retires, will not be nearly enough.

This is why the returns on your investments must be with inflation in mind. Assuming an average inflation rate of 1.75%, investors with money in a savings account collecting 1.5% interest are actually losing purchasing power.

How do I figure out how much I need?

It’s fairly easy to sit down, estimate the costs of what you want to do in retirement, and come to a final number. But unfortunately like we talked about above, inflation gets in your way.

A simple calculation of this would be to predict your spending in retirement, and for this case we will use 75% of your pre-retirement income on a $60,000 salary.

We’ve figured out we want to have a budget of $45,000 a year in retirement. Assuming you’re 30 now and want to retire at 60, with the average lifespan of a person in Canada being 82 years, you would need 22 years of retirement income, or about $990,000.

However, the key thing to note here is that this is retirement income expressed in current dollars. Assuming our 1.75% average inflation rate, in order to calculate how much you’d actually need, you would take your initial retirement nest egg needed and multiply that by the price of inflation to the power of the years until your retirement.

The calculation would simply be:

$990 000 x 1.0175^30 = $1.665 million.

As you can see, you need significantly more than your original $990 000. In fact, over the next 30 years, your gross pay would be $1.8 million. So it would be impossible to save this amount.

Keep in mind, this isn’t factoring things in like company pension or your Canadian Pension Plan payments. But it is a solid baseline to start actually figuring out the dollar amounts needed for retirement. Also, this calculation can be factored in to any sort of goal you have constructed. If you’ve got $20,000 stored away for a down payment on a house in 5 years, that $20,000 will only be worth $18,338 with inflation.

Inflation aside, focus on your real rate of return

The point of investing is to make money. But sometimes making money on investments simply isn’t enough. There needs to be a minimum amount for you to keep your head above water. Like the example above, if you’ve got your money in a savings account making 1.5% and inflation is going up at a rate of 1.75%, your real rate of return is actually negative. Your money is losing purchasing power.

We want to avoid this. As long as your investments keep up with inflation, any extra made is actually adding to your purchasing power. An investment portfolio earning 10% has a real rate of return of 8.25%. Let’s go over a quick example.

We have 3 situations. You have $20,000 in every one of them. The first situation, the money is simply in your chequing account, not earning any interest. The second situation is a 1.5% savings account, and the third is an investment account earning 10% a year. Lets have a look at the total purchasing power of your money after 10 years:

Situation A: $16,814

Situation B: $19,505

Situation C: $44,188

Quite a difference right? In 10 years, your money has lost 16% if you had it sitting in a chequing account, 2.5% if you had it in your savings account, but has more than doubled if you had it invested. Keep in mind your actual amount of money in situation A is still $20,000, but the amount of purchasing power it has, has gone down. A leaky pipe today may cost you $75 an hour for a plumber, but in 25 years it may cost you $101. That is the power of inflation.

As long as your real rate of return is positive, the money you save today will keep up with inflation and then some, allowing that $990k nest egg you need to turn into that $1.665 million.

Get your numbers straight

So, you’ve figured out the dollar figures you need to enjoy the retirement lifestyle you’d like or the home you’d like to own 5, or 10 years from now. If you haven’t, take the time to do so. Afterwards, your job is now to figure out how much you need to save, and the real rate of return you need to achieve that nest egg. Savings calculations and risk tolerance will be covered in part 2.

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