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Portfolio Construction – Part 2

Welcome to part 2! Lets get right into it. During this portion of the guide, we’ll actually start getting into building your investment portfolio.

We’re going to follow our example of a 30 year old millennial making $60,000 a year, hoping to spend $45,000 a year in retirement, with zero savings currently. We’re going to ignore pension plans such as your individual work plan or Canada Pension Plan strictly for simplicity. The easiest way to factor these in would be to find your pension amount per year, and subtract it from your retirement spending budget to figure out how much you’d need to fund by yourself.

Part 2 – Savings Calculations and Risk Tolerance

Assuming our 8.25% real rate of return, if our investor wanted to retire with their current goals in mind, they would need $1.6 million in 30 years.

In order to do so, they would have to save approximately $13,489 dollars a year.

This number seems somewhat impossible on a $60,000 income, and it probably is. After income taxes and living expenses, it would be very hard to save this amount. But, after you factor in your pension contributions and other assets like a mortgage, your dollar amount will surely go down.

An investor can also decrease (or increase) their amount needed to be saved by increasing their real rate of return. Nothing is without risk though, which is why constructing an investment portfolio that fits your needs is absolutely crucial. If this particular investor was so passive that they invested only in bonds paying on average 2.5%, it would be impossible for them to reach their retirement goals. However, an investor with a target real rate of return of 10% would only need to save $9,700 a year.

Finding a comfortable risk tolerance

Every form of investing involves risks. Although bonds and GICs are generally considered risk free (depending on the grade of bond), they still pose risks. As an investor, you need to find a comfortable risk level you’d be willing to take to achieve your goals. This will vary from investor to investor, and those with a higher risk tolerance are subjected to significantly more volatility.

One quick and simple way to get the ball rolling on determining your risk tolerance is the following quiz from Rutgers University. I scored a 34 myself, meaning I am comfortable with the most aggressive styles of investing. What I would be willing to consider being normal, may be extremely uncomfortable for someone else. This is why you need to determine your risk tolerance before even thinking about creating a portfolio.

The determination of your risk tolerance will have a large effect on your minimum saving amounts, as it will truly define the amount you need to put away to be able to meet your retirement goals at the age you have decided. An aggressive investor may be able to retire 7 years earlier than one who has invested conservatively their whole career, but if taking an aggressive approach is causing you to lose sleep at night, it may not be the best course of action.

Once you’ve decided how much risk you’re going to take, the fun part begins

By fun, I simply mean you can finally begin to construct your actual investment portfolio. Some of you may have already figured out the answers to the questions posed in part 1, and some of part 2, but it is crucial I included them anyways, as they are steps that cannot be skipped.

You’ve now got your retirement or short term goals, the amount you will need to spend at that time, the amount you will need to save to meet those goals, and the amount of risk you are willing to take to achieve those goals. Depending on the amount of risk, your target date may have been shorter or longer than expected.

If this bothers you, the best route to take, if possible, would be changing your amount you need to save to meet these goals. You can’t change your risk tolerance, and investing outside of this tolerance can ultimately cause you to make mistakes that leave you worse off than you would have been if you had stuck to your original goal.

Part 3 is going to talk about asset allocation and portfolio diversification.

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