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Reengineering My Portfolio Management, Part II: Portfolio Objectives & Constraints

Contributed by mm | February 16, 2007 4:34 PM PST

A good starting point in our portfolio management discussion is a reflection of what we expect out of our portfolio. Enough detail of our family finance has been given in this blog but it suffices to summarize the relevant facts below:

TIME HORIZON:

Our current financial aspiration is to work hard and build enough wealth that will allow us to live a semi-retirement life well before the standard retirement age. Nowadays, we expect we will need to accumulate $1.5M to $2M in US dollars before we can have the gut to say goodbye to my still-growing corporate career and start our semi-retirement life with sufficient safety margin. Considering of what we make this far ($660,000 by the end of January 2007), and our healthy cash flow ($300,000/year from job and business income; $150,000/year after expense and taxes), we expect to be in that position in 5 to 10 years.

Even if I leave my corporate life in 5 to 10 years, I still expect to make some money from part-time consulting jobs, and income from our sideline business is likely to sustain, too. Therefore, we only need to withdraw from our portfolio in a very limited fashion until 15 to 20 years from now (and our hope is the portfolio will grow to $3M or more by then).

LIQUIDITY:

While we will not need to withdraw from our portfolio on a regular basis until at least one decade from now, there might still be some events down the road that may require us to withdraw on a one-off basis. Our liquidity constraints are quite limited:

• $50,000 liquidity in a week (e.g. medical emergency for extended family members, etc.)
• $200,000 liquidity in a month (e.g. down-payment for home purchase -- will we be a renter forever?)

RISK TOLERANCE:

Given the 15-20 year time horizon, and the fact that we can absorb some fairly significant investment loss by simply postponing our early retirement by one year or two, we can be fairly aggressive and risk-taking in portfolio management. On the risk side, we can accept annual loss of 10% of our portfolio without losing our sleep at night.

RETURN EXPECTATIONS:

On the other hand, we also seek matching investment returns for our risk appetite. We expect 10% or more absolute return per annum on average for the next 15-20 years. (That is, to double the size of the portfolio every 7 years -- without injection of more principal.)

Both my wife and I were raised in China. While we are becoming world travelers, we do feel we will spend a lot of our retirement life (and hence retirement fund) in China. Therefore, it is important our portfolio provides some hedge against declining dollar value. Our hope is our absolute return denominated in Chinese Yuan will be 7% or higher after 15-20 years.

TAX CONSIDERTIONS:

Aside from the no-brainer of preferring tax-advantaged growth (401(k), IRA, Roth IRA, etc.), we also hope our portfolio can allow us to time when we want to book any capital gains. Our upcoming early retirement, our business income and ever-changing tax laws will create tons of tax opportunities that, if used properly, will dramatically reduce our tax burden on portfolio appreciation.


To sum it up:

PORTFOLIO OBJECTIVES:

- Seek annual absolute return of 10% or more in US Dollar
- Seek annual absolute return of 7% or more in Chinese Yuan

CONSTRAINTS:

1) Time horizon of 15-20 years before regular withdrawal happens.
2) Some liquidity needs: $50,000 in 1 week and $200,000 in 1 month.
3) Medium risk tolerance: 10% annual loss is acceptable.
4) Tax flexibility needed: being able to time the realization of most capital gains.

Next, I will explore how I should distribute my portfolio across different asset classes.

This Post Has Received 7 Comments. Share Your Opinions Too.


Jamie Commented on February 17, 2007

You do a great job benchmarking yourself against objectives in other parts of your life. But your investing seems to be lacking that sort of benchmark.

I understand that stock-picking is fun, but I would offer up the following challenge. Track your results against a diversified index fund portfolio and see if all of your hard work (as well as real trading costs) results in any deviation. I would recommend benchmarking against one of the www.ifa.com portfolios. (Mine is the 95 portfolio, but you could just choose one based upon your risk portfolio.)

So far, even with their too high expenses (1%), I think that my portfolio is beating you handily. But my point is less that, than that I think the overall research strongly favors the view that your efforts to construct a new portfolio will result in disappointment versus a lazy, well-constructed passive approach.


fin_indie Commented on February 17, 2007

I disagree with the first commenter. Although the bedrock of my portfolio is made up of index funds, you can significantly augment your returns by also picking a few well researched value plays. By this, I mean: significantly undervalued, strong companies bought as investments, not trades. This is how you *beat* the market.


SG Commented on February 19, 2007

I think you are dreaming if you believe you can earn 10% as an average annual return with any portfolio. If you read Bernstein "Four Pillars" you will know where I am coming from.


Orthros Commented on February 26, 2007

I have to agree with the 1st commenter.

There is a disconnect between being willing to lose 10% of your portfolio in a year yet wanting 10% annual returns.

As a rule of thumb, take your stock % mix (say, 80%) and halve it. That is your potential annual loss, which for an 80% stock portfolio equals a 40% loss (equivalent to the '73/'74 bear market).

If you want a 10% maximum loss, then you need to shift heavily to bonds (i.e. 20% stocks / 80% bonds).

I also recommend "The Four Pillars of Investing" by Bernstein for a great eye-opener and a realistic view of long-term risk and returns.


MM Commented on February 26, 2007

Orthros, yes, there is always a chance the world will no longer exist next year, but losing half of the value in a sufficiently balance portfolio is really a six sigma event to me.

In fact, whether I use this allocation to earn 10% or 8% a year in the long run does not matter too much ... as long as I stay on a fairly aggressive side.


MM Commented on February 26, 2007

On "The Four Pillars of Investing", all I can say is I've seen enough evidence to 1) suggest market is inefficient -- such discussions are available in any good textbooks that talk about EMP, and 2) value investing brings persistent alpha. I cannot say index investing is bad -- it will do as good as the market -- but I do believe one can do better.


Darwin Chu Commented on April 17, 2007

The Rolling Stones cancel a gig in Hawaii and postpone other tour dates as Mick Jagger suffers throat troubles...


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