Learn more than basic portfolio advice and take a much deeper dive. This episode explains how we can measure our portfolios (more than just returns), and why financial advisors give the advice they do. It discusses what volatility is, why it’s important, and how our portfolios should change as we change. Finally, we discuss important things to look for in choosing a broker that can help you save money and fulfill your goals.
With that! Here are the links.
If you have iTunes please use that as it helps my rankings within the store. Don’t forget to subscribe to stay updated on future episodes!
You can find the script of this podcast at the bottom of the E-mail.
Here is the script that was used in today’s episode.
Note: I don’t follow scripts word-for-word as they can sound unnatural, but the episodes do closely follow them.
Episode 3 – Yes, I’ll have one portfolio and broker please
This is episode 3 and today we’re going to use everything we learned to create a basic portfolio. Before I begin, I just want to say a big thank you to the amazing reception this podcast has received. It’s gotten 33 5 star ratings in two weeks and over 800 downloads across the world. The feedback I’ve received has been incredible and I look forward to continuing this series. We are now an international podcast.
Let’s move on to the topic!
Since we’re about to get a little bit edgy, I want to state here that I am not giving financial advice. I want this podcast to empower people with the knowledge and tools so they know what they want and can create it! I don’t know the financial situation of my listeners so it’s important to me that your knowledge will be flexible enough that you know what you want to do. I want to empower people will the freedom of not having to rely on others for financial advice, but knowing they can rely on themselves. And if you, the listener, do choose to rely on financial advice – it will be because of convenience and you will be able to understand your advisor. You will be able to follow along with them, ask them questions, challenge them, and make sure you’re getting what you’re spending your hard earned money on.
Let’s continue on. For this episode, we will first discuss what is a portfolio, what are common principles we should keep in mind when designing a portfolio, the different types of investments that exist when designing one, and in the end we will discuss how you can choose a broker and all the things to keep in mind when choosing one.
To begin, let’s talk about what a portfolio is. A portfolio simply means a group of investments that we hold. It could be just one investment to thousands. In this episode we’re going to talk mostly about pooled investments, specifically index funds. The general consensus is that a portfolio of different kinds of index funds is the best thing to do as a beginner. It’s easy, less work, low fees, and studies support it’s the best way for new investors to get the highest overall return.
Now that we’ve defined a portfolio, we have to figure out some way to measure what’s good or not. After all, what good is having a portfolio if it loses us money. In previous episodes we discussed how a return on an investment is a way to measure if it’s good. A return is simply saying, how much money do I make for every dollar I put in? We measure our portfolios the same way. If I said got 6% this year. So if I had $100,000, I made $6000. My portfolio is now $106,000. But there’s a twist to it.
Let’s say we had $100,000 on January 1st 2015. On December 31st, 2015 we had $106,000. So overall we made 6%. But what if the market took a terrible turn and in the first 6 months of the year, we lost 30%…so on June 1st 2015 our $100,000 investment was now at $70,000. How would this make you feel? This really wouldn’t make me feel so good. Then let’s say the market quickly rebounded and recovered and you ended up making $36,000 in the next six months. So overall, you came out 6% higher.
Now let’s take another scenario. Let’s say we still ended up with $106,000 by the end of the year. But when June came around, this time markets were much more tame and we made 3%. So we made $3,000 and our portfolio was $103,000 by mid-year. This time markets continued to remain team and we made another $3,000 so we ended up the year with $106,000 – or 6%.
Now which of those sounds more appealing? We both ended up with the same amount of money, but in the first case markets were a massive rollercoaster. The reason most of us prefer #2, unless you got some sort of adrenaline problem going on, is because less of something we call volatility. The second case has volatility. Volatility in very simple terms, means how much something moves around. In our portfolio example, the first portfolio had a lot of volatility, it’s value changed considerably in a short amount of time. In the second case, our portfolio was growing slow and steady, so it didn’t have as many wild swings. It is said to have less volatility.
So volatility is actually a super complex topic many mathematicians, financial professionals, traders, and academics spend so much time on. Because of this, We’ll probably dedicate an entire episode to in the future.
But the core of what I am saying is, that returns are not the only thing we care about. We also care about the volatility of those returns. We want something that gives us the most amount of return for the least amount of volatility. People often say volatility is a measure of risk. The riskiness of our portfolio is determined by the volatility.
Why is that? There are a couple reasons. First let me mention, volatility has no direction. It can go up just as fast as it can come down. Actually, in practice you’ll se in markets, that markets crash much much quicker than they go up. If you pull up a chart of the S&P, you can use the ETF called SPY. You will see gradual moves up, the quick sudden violent crashes.
Let’s say we started with $100,000 again. And this time let’s say we are in a high volatility portfolio. Our portfolio at first does very well and doubles. It has a 100% return. We now have $200,000. Now let’s say, because it has such a high volatility, it goes down 80%. What is our portfolio worth now? It is now worth $40,000. Now let’s say it goes up 100%- so it doubles. It is now worth $80k. You see, even though the price doubled twice, because it fell by 80%, it never fully recovered. It doubled, lost 80%, then doubled again. This is what volatility does. But what if the portfolio fell 80%, but instead of going up 100% for a second time. So it doubled, went down 80% then another 80%. That $40k you had left would now be worth $8k.
So when we hear about somebody making a lot of money, we have to ask, “well how volatile was your portfolio?” Because if they doubled their money in 2 weeks, it could go down more rapidly in the following 2 weeks. The goal of this podcast is to create a portfolio that maximizes our return and tries to minimize volatility.
So let’s move on to discuss a standard portfolio that people use to try and achieve this:
Stocks and bonds
I want to begin this by going over a couple starter portfolios. Often if you google what you should do to start investing, you get all sorts of answers and long answers. You read and read read and it’s frustrating because nobody gives you a straight answer. Then you come across an article that gives you a very straight answer but doesn’t get into the nitty gritty. And this is where I want this podcast to be helpful for you. We’re going to work backwards – we will discuss why people give you these quote, “rules of thumb” and then get into the nitty gritty. Cool?
Awesome! Let’s talk stocks. Typically, stocks return between 9-10% on average a year. Government bonds return between 5-6% a year. The standard blanket financial advice is, you should be in 60% stocks and 40% bonds. Now why is that? We discussed in episode 1 how AAA bonds, are typically seen as safer. AAA is a credit rating of a country or company, it is the highest rating. Think of it like a credit score for the country or company. AAA is the highest credit score a country or company can have. Because bonds tend to be safer, they return 5-6% on average. The volatility of stocks tends to be higher than bonds though. So notice how the returns of stocks are higher than bonds but the volatility is higher. People typically say stocks are riskier, but the market gives you more if you want to take that risk.
That’s a general guideline of markets: If you are taking more risk, you should be paid more. If you are taking less risk, you should be paid less. If you are taking more risk and not being paid more, that’s not a good thing.
So because of these reasons, a balance between stocks and bonds is often recommended. Stocks and bonds do not typically move together, but they both return you money. This is a concept called positive expected value. We invest in stocks, bonds, and other things because we expect them to make us money. They have a positive expected value. But if two things don’t move together, that’s diversification. They both will make us money in the long run, but they may take different routes to get there. When one goes up the other may go down or stay the same. This helps stablizies things. For example if stocks drop 4% and bonds go up 2%, our portfolio is better off than if we were all in stocks.
Over time though, they both are expected to make us money, just taking different paths to get there. We will talk more in depth about how to measure how they move together in Episode 4 of our series.
Bringing it back, what about the 60/40 portfolio recommendation where we are 60% in stocks and 40% in bonds. How does it do? First let’s establish something to compare it to. Let’s see how a purely stock portfolio would do.
If we invested 100% of our portfolio in the S&P in 2005 and left it alone, That’s ten years prior to today, what would happen? Well today, our portfolio would be up 73%. It would be worth $173,000. What would happen in the 2008 financial crises though? Well stocks fell 45% at one point, so if we invested $100,000, in 2008 we would’ve had $55,000 at one point. In 2015, we would have $173,000. That a heckuva rollercoaster!
What about our 60/40 portfolio? Well if we started it in 2005 and left it alone, it would be up 60% today. So $100,000 would be worth $160,000. What about 2008? It went down approximately 25%, so, it would have been $75,000 at one point. Compare that to a portfolio that was fully invested in stocks. Our lowest point would be $75,000 versus $55,000 for stocks. At the same time, we would end up $17k short compared to our all-stock portfolio. This is an example of the risk-reward tradeoff.
I’m going to ask you all to picture something, some of you did not have to witness. Imagine your portfolio was entirely stocks. Your entire retirement portfolio. Now imagine it is 2008 and you are going to retire next year. You are 64 years old and planning to live off your retirement. But now a financial crises happens, and you lost almost half of your entire retirement portfolio. How would you feel?
Unfortunately this happened to a lot of people. It was a devastating event for many people nearing retirement. Not only that, jobs were harder to come by as the retirement rate skyrocketed.
And this is a big issue with the 60/40 model. It doesn’t change as you change. As you approach retirement, you probably want to be in something more stable and you’re willing to take less of a return because of it. You don’t want to be close to retirement and potentially lose a lot of money.
SO that brings me to the next rule of thumb:
“100 minus your age” This means, you take 100, subtract your age, let’s pretend you’re 30, so 100 minus 30 gives us 70. That 70 represents the amount of your portfolio that should be invested in stocks. So if you are 50, that’s 100 minus 50, and you should be 50% in stocks. The other portion is typically bonds. So if you’re 30, 70% stocks, 30% bonds. If you’re 50, the 50% stocks and 50% bonds. 100 minus your age
Keep in mind, this isn’t financial advice from me, I will try my best not to give advice, but this is the commonly held advice that advisors share. The reason this is preferred to the 60/40, is that the portfolio changes are your situation changes.
As you get older, you may want to take less risk.
Now you may feel comfortable changing up this allocation tp whatever combination fo stocks and bonds that you like, but the reason I like this rule of thumb better, is that it encourages us to think dynamically. It gets us to question “how much risk can I take?” as we get older, change jobs, maybe you have kids, grandkids, want to start a business, anything!
And I think one of the best measures I ever heard for assessing whether you’re comfortable with the risk or volatility you’re taking is this, “Are able to sleep at night?” If you’re going to bed worried and the like, your portfolio is probably too volatile.
I told you some statistics behind the 60/40 allocation, but I don’t know you’re age so how do you know how much you would make or lose in 2008 using the “100 minus age” formula? Well I created a tool at Tiingo.com so you can run the same statistics I did! You can take your current portfolio, or a theoretical portfolio – what you want to invest in, and see how it would perform if 2008, 2001, or any time period repeated itself. This in finance is called a backtest. So to use it, go to Tiingo.com , two iis, and then click portfolio at the top. From there type in the stocks or etfs that you own and the number of shares. Once you do that go to the top right corner where it says overview, and select backtest. The rest is self explanatory! I created some time periods for easy use just to make things easier. This is a tool many hedge funds may $20k/month for more and I want to make it free for you all
Okay so we’ve discussed two different start portfolios: a 60/40 allocation a “100 minus your age” allocation. So maybe you now have an idea in your head of what kind of mix of stocks and bonds you want. What do you actually trade to get them?
Going from our previous episode on pooled investments, a lot of research and advice tells us, as newbie investors we should stick to index funds or ETFs. The reason is that it takes a lot of time, effort, and research to select a mutual fund that may outperform. There are many kinds of ETFs out there for stocks, you will see small cap, which means smaller sized companies, to large cap. The S&P 500 is considered large cap.
So sticking with a basic stock index ETF you could use SPY or VOO. Throughout this podcast you’ve heard me say SPY, and one of the main reasons is that it’s sort of an industry standard. It also is the most widely traded S&P ETF. But if you’re looking at lowest fees, the Vanguard product VOO can’t be beat. It has a management fee of .05%.
For bonds, there are many different kinds of ETFs. A common one used in the industry is TLT, the Barclays 20+ year government bond fund. This only invests in U.S. government bonds, considered very safe. Like SPY, you may hearme say TLT as it’s sort of an industry standard. But you can use something similar made by Vanguard, and that ticker is VGLT. It has a lower expense ratio than TLT. And I promise you, I’m not being promoted by Vanguard. In fact, I told them about this podcast hoping for a retweet and they pretty much said “cool bro.” in more corporate terms. The reason is that Vanguard tends to be the industry leader in reducing fees.
Of course there are many different kinds of stock and bond funds. Things like growth stock funds to value stock funds. Same with Bond ETFs. We will get into those topics later down the line.
But for right now with two ETFs, VOO and VGLT, you can have a basic portfolio. You got your stocks represented by the VOO ETF and you got your bonds represented by the VGLT ETF
Ok let’s go buy us some ETF!!! Oh wait…we need a broker.
So to choose a brok – wait let’s stop for a moment and appreciate how good that transition was….k im over it. You probably aren’t though, so ill pause one more second…
OK cool! So now we need a broker to wrap this all up. A broker is a company that helps us execute trades to buy and sell stocks, mutual funds, index funds, ETFs, and so on. How do we choose a broker? I’m not going to recommend a broker, because that’s not my style and frankly – I cant. Each and every one of you has unique circumstances so one broker may be better for you than another. I want to help you find which broker suits your specific needs.
If you are listening to this episode, chances are you are going to be looking for a discount broker or opening a brokerage account with a mutual fund company. There are two main types of brokerages, a discount broker and a full-service broker. Full service brokers typically provide all sorts of services like advising, tax planning, etc. They are also much more costly.
The websites you typically hear about like TD Ameritrade, Scottrade, Tradeking, and so on are called discount brokers. The way these brokers work is they charge you a fee each time you buy or sell a stock, mutual fund, index fund, ETF, and so on. So you get charged both on buying and selling. Typically these fees range from $5 to $10 for stocks and $10-$50 for mutual funds. Here is where things can get tricky: a lot of these brokerages have partnerships or offers where they will give you discounts on specific ETFs, mutual funds, or index funds. So you may not end up paying any commission on certain products!
You can also choose to invest directly with a mutual fund company by creating an account at Vanguard, Fidelity, and the like. The benefit to these is that they typically don’t charge any commission or fees on products they offer. This is nice if you know you’re going to stick to a specific company’s products. The downside is that if you do want to buy stocks or use another firm’s ETFs or mutual funds, it can be cost you another $10-$20.
So these transaction fees can be pretty significant, especially if you’re just starting to invest. Let’s say you had $1,000 to invest. Let’s say you went to broker RoadRunner Brokerage Company (I’m making this up), and they charged you $5 every time you bought or sold an ETF. Well that’s $10 total, which is 1% of your $1000. So with $5 commissions each way, you’re going to be in the hole 1%! Let’s see we went to Coyote Brokerage Company and they charged $10 to buy and sell. That’s $20 total which is 2% of your $1,000 initial investment! These fees can add up a lot, especially if you think you will be trading frequently. So generally, you want to evaluate how much you will be trading, which products you will be trading, and make an estimate of the fees you will be paying at each broker.
There are also a few other fees you should be wary of and decide if it makes sense for you. Some brokerages charge inactivity fees, so if you don’t make any trades, they apply a fee.
The next thing I want to quickly discuss, is that if you go for a brokerage that isn’t popular, make sure they are SIPC insured. SIPC stands for Securities Investor Protection Corporation. When you deposit money in a bank, it is insured by a federal agency known as FDIC up to $250,000. The SIPC works similarly except for two major differences. It is NOT a federal agency but is federally mandated. The second is, that the SIPC will not protect you if you lose money by trading. It will protect you though if your brokerage goes bankrupt up to $500,000 and up to $250,000 can be in cash. It will not protect you if your broker misleads you with poor financial advice that loses you money.
Finally, in addition to the SIPC, each broker may get additional insurance to protect you for more than $500,000. If you fall into that category, take the time to call each broker and ask if they do. The websites can sometimes feel very confusing and almost like there are fees everywhere. Also take the time to google the broker and see if people have complaints about them.
Before we conclude our bit on brokerages, I want to pre-emptively address a question you may have. The sign up process for a broker is relatively straightforward, but many people pause at the question of “margin.” What is margin? Margin means you can borrow money from your broker, and then use that money to trade. You can basically take the cash in your account, double it, and use twice the money to trade. I HIGHLY HIGHLY DO NOT RECOMMEND THIS IF YOU ARE A NEW INVESTOR. IF YOU THINK YOU WILL BE TEMPTED, THAN YOU PROBABLY SHOULDN’T. The upside to a margin account is that when you sell out of a stock, ETF, or Mutual fund, it will take 3 days for the money to hit your account so you can trade again. This is abbreviated T+3. Today + 3 days. So if I sell out of a stock on Monday, I can ‘t trade with the proceeds of that sale until Thursday.
This is because there is clearing work that needs to happen, so you will not have access to the money until it happens. If you have margin, a broker will typically let you trade with that money as soon you sell out of the stock. So instead of having to wait T+three days for the money, if you have a margin account you can sell out of your stock, ten buy another with the money same day. SO if you sell out of your stockon Monday, you can buy more on Monday
Once you get your broker set up, you can transfer money and begin trading!
Wow we covered a lot in this episode. To recap, we talked about…A LOT. Haha. We’ve made amazing progress all. In just three episodes we now have a better understanding of what’s a portfolio, how we use returns in the context of volatility, two different types of portfolio allocations and their drawbacks and benefits, and how to choose a broker.
If investing in a company was like setting up a piece of equipment, we just did the “Quick start guide” Get ready friends because we’re about to read the entire manual…except the non-english translations. That might get redundant and I don’t want you confused as to why I suddenly started speaking fluent French. Actually, I don’t know how to speak French so I would be confused also.
So in the next episode we’re going to talk about correlation and beta. These are two metrics we can use to measure diversification. Understanding these will help us trade more than just large stocks and US bonds. We’re going to be breaking into more types of investments once we get these concepts down! The stocks, mutual fund, index fund, and ETF world is massive, and these metrics will help us narrow down the assets we care about!
Alright all! We’re awesome, you’re awesome and I loved making this episode. If you have any questions for me or feedback, please E-mail me at [email protected] I love hearing feedback, whether it’s good or bad. I mean, everybody always likes compliments so you can always drop 1 or 2 in there too.