Tips before rebuilding our asset portfolio

When the market is so volatile, it's easy to get carried away with the day-to-day price action and lose focus. That's why this is a great time to go back to square one for a complete investment revamp and build our portfolios from the ground up. And one of the first steps to do this is to create a investment policy plan (IPS) that describes our investment objectives, establishing a roadmap for our investment activity and, ultimately, determining the outline of our portfolio. We can easily do this by looking at the four main elements of an IPS.

1. Time horizon: What is the timeline of my goals?⏱️✅

The first step to creating an IPS is to define our investment objectives and how much time we have to achieve them. If we have 45 years and we are investing to finance our retirement at age 65, for example, we have a long-term horizon: 20 years. On the other hand, if we are 25 years old and want to buy a house next year with the money we invested now, we have a very short time horizon. To figure out ours, we have to ask ourselves what our investment goals are and what our timeline is.

Our time horizon has a large impact on our ability to take risk and, in turn, the composition of our portfolio. The longer our horizon, the more risks we can take, because we will have more time to overcome short-term market volatility, recover from investment losses, and replenish our account with future savings. The shorter our time horizon, the less risk we can take. Let's imagine we retire next year: a large investment loss could have a huge, negative impact on our ability to fund our retirement.

2. Liquidity needs: How often will I need to withdraw cash?

A liquidity need is a demand for cash beyond what we are saving in our investment account. If we have to regularly withdraw cash from our investment account to finance ourselves, then we have high liquidity needs. If that is the case, we should invest mainly in liquid assets, that is, those that can be easily and quickly converted into cash. High liquidity needs also reduce our ability to take risk: if we rely on constant cash withdrawals, a large investment loss could be disastrous.

However, if we have low liquidity needs, we can take on more risk and invest in illiquid assets like private equity, real estate, and even collectibles like art and classic cars. These assets can boost the profitability of a portfolio. And since many of them tend not to follow traditional asset classes, they can increase the diversification of a portfolio and reduce overall risk. If we have a long-term horizon, we are likely to have lower liquidity needs and can dedicate more of our portfolio to illiquid assets.

3. Risk tolerance: How much loss can I bear?❌

This has to be determined in terms of our willingness and ability to take risks. Of the two, the latter should generally prevail. In other words, if we have a great willingness to take risks but little ability to do so, we should definitely avoid it as it could lead to disastrous financial results. However, if we have a high ability to take risks but little willingness to do so, we may miss out on potential gains by investing too conservatively. If we're still having a hard time deciding which side we're on, it may be best to invest conservatively. We may lose some profits, but we will avoid regularly making poor investment decisions in response to market volatility.

If a small loss leads to a disastrous financial result (For example, it prevents us from adequately funding our retirement next year), then we have little capacity to take risks. If, on the other hand, we can lose all our invested money without harming our current financial situation and it does not prevent us from achieving our investment objectives (because we have a long-term horizon, a well-paid job or capital elsewhere), then we have a very high capacity to take risks. One way to quantify our risk tolerance is to specify the maximum acceptable reduction we can live with. The maximum drawdown is the largest peak-to-trough decline in the value of a portfolio. Something between 0% and 20% means we have a relatively low risk tolerance, between 20% and 40% is considered medium, and above 40% is high.

4. Return objective: How much money do I expect to earn?螺

There's a reason specifying this is the last step in creating an IPS: your time horizon and liquidity needs help determine your risk tolerance, which, in turn, determines your return target. So if you're investing conservatively (because you have a low risk tolerance), then you don't want to set an unrealistic high return goal. This performance goal should be set as a long-term average, not a goal that you hope to achieve every year. Markets are unpredictable and such a goal is unrealistic. Ideally, the return target should also be stated as a real return, i.e. a return after inflation. American stocks They have generated about 7% average annual real return since 1928, and US government bonds about 2%. This helps give you an idea of ​​what kind of actual return you should expect: something between 2-7% is realistic depending on your risk tolerance.

Once we've established a return goal, you can use BlackRock's capital market assumptions to get an idea of ​​what asset classes you can include in your portfolio to help you achieve that goal. These are the BlackRock expectations of returns of different asset classes over different time horizons taking into account the current macroeconomic environment, valuations and more. Please note that BlackRock's performance assumptions are nominal, i.e. before inflation. To arrive at real yields, simply subtract 2% (a good indicator of long-term inflation expectations) from each of them.