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What is the perfect portfolio for salaried individuals?
I am asked this question all the time & people, more often than not, struggle to grasp the answer that I have. Hence, I decided to undertake this opportunity to share my thoughts on this topic by presenting a theoretical framework followed by some guidance.
Please be advised that this is not financial advice. Portfolio construction & allocation decisions depend on an individual investor’s particular circumstances.
If you are a salaried individual unable to decipher how to construct & allocate your financial capital, this article will merely provide a logical framework that should get you started. For detailed advice, consult an investment advisor.
Let’s go then.
Portfolio for Salaried Individuals – Goal Setting
Goal setting is important to portfolio management. We need to know the goal the portfolio will target to meet. This goal setting provides us with:
- a known target rate of return;
- a known risk level to target;
- the time horizon available
In the real world, investors may have multiple goals. Each goal will have a bearing on the ability of the overall portfolio to satisfy them. The investor can be educated to prioritize goals if the portfolio is insufficient or expectations are too high.
To keep things simple, for the purpose of this article, we will make certain assumptions. These are:
- The investor has only one goal, that is, maintaining their standard of living into retirement based on the last salary drawn adjusted for inflation;
- The age of entry into the workforce is 25 years & retirement is once the investor is 60 years of age;
- The dividend & fixed Income generated by the portfolio is reinvested.
Portfolio for Salaried Individuals – Concept of Human Capital
No discussion on portfolio management will be complete unless we look at an investor’s total capital. This is financial capital (the portfolio) plus human capital.
All future income from entrepreneurship or wages received today is defined as human capital. This is a present value discounted at an assumed rate. Human capital is the highest at the inception of one’s working life and lowest near or at retirement.
Entrepreneurs and self-employed individuals are deemed to have human capital that represents equity. It is uncertain when & how much money & when a self-employed person will make.
Equity investments are not too dissimilar. Whether a company announces a dividend or not and what will be the behavior of the share price cannot be modeled. Hence, the element of risk is high.
Similarly, for salaried individuals, human capital is said to closely represent fixed income. A salaried individual receives a fixed, regular income every month.
Fixed income investments are not too dissimilar. The interest a company pays on its bonds & their dates can be modeled. Hence, the element of risk is low.
Therefore, for entrepreneurs & self-employed individuals with equity-like human capital, portfolio allocation should be tilted towards fixed income. Similarly, for salaried individuals with fixed income like human capital, portfolio allocation should be titled towards equity.
Portfolio for Salaried Individuals – Other Factors
Considering the characteristics of human capital in isolation would be too simplistic to make portfolio allocation decisions. One must appreciate other factors.
Industry
Employees in most cyclical industries like commodities, automobiles, cement, steel, and building materials are more at risk than employees in healthcare & education.
These industries do well when interest rates are low, financing from banks is available cheaply and the economy is booming. Reverse these factors, and you find that these industries struggle.
Over time, due to the cyclical nature of these industries, we observe that the rate of salary growth shows variation as well as performance-linked pay. Hence, one cannot conclude that the human capital of the said individual is similar to fixed income.
The same is true for a self-employed individual who owns a pharmaceutical or fertilizer company. Barring extreme events like war, pandemics, and famine, the demand for products and services of these businesses remain inelastic.
Cyclical factors such as interest rates, monetary policy, or growth rate do not have a high impact on these industries. Therefore, we can conclude that the entrepreneur’s human capital is not equity-like.
Age
Portfolio allocation should also take into account the age of the investor. Higher allocation to equity is preferred for a 25-year-old individual just starting out on his job.
If the market turns negative, the long time frame to retirement allows for short-term portfolio losses to be recovered.
This higher risk-taking ability diminishes as a salaried individual ages. At 50 years of age, equity allocations to the portfolio should be a minority & virtually non-existent near or at retirement.
This is because at or near retirement, the individual does not have the flexibility of time to recoup short-term volatility in equity markets & thus runs the risk of portfolio shortfall at retirement.
Attitude to Risk
As investors, it is important to understand one’s attitude to risk. In our case, the probability that the portfolio will fail to achieve the stated goal by a certain margin is called risk.
Investors need to be cognizant of the consequences of such risk-taking on their portfolio, investing goals & standard of living. Too high or too low-risk tolerance could lead to suboptimal portfolio decisions & eventually portfolio underperformance.
Diversification
As investors, it is also necessary to consider diversification. This had implications on both the choice of asset classes & security selection within an asset class.
Traditionally, investors have constructed portfolios by allocating capital between equity and fixed-income investments. There has been little to no consideration for alternative investments, which may act as return enhancers or risk mitigators.
This trend has changed & we now have empirical evidence to support that diversified portfolios have some sort of exposure to alternative investments, which include:
- Real estate (inflation hedge & diversifies risk);
- Hedge funds (increase return & diversify risk);
- Commodities (inflation hedge with potential for increased return and diversified risk);
- Private equity (increase return & diversified risk);
- Digital assets (Increase return & diversified risk).
That being said, regulatory oversight & barriers to entry prevent the availability of many of these investment vehicles to the average salaried individual.
Similarly, the traditional thinking on the street also identifies with holding two or three hot securities from time to time. This leads to short-term orientation in the pursuit of long-term goals & over-trading.
Such suboptimal decisions need to be avoided & salaried individuals should choose passive investment strategies as opposed to active ones. This is because of passive investment strategies:
- Delegate the research & execution process to experts;
- Enable diversification;
- Allow the investor to concentrate on his job & family.
The Perfect Portfolio for Salaried Individuals
We now put our background into practice by developing a portfolio for salaried individuals on a sample basis. In my opinion, this is how I would like to go about things for myself.
Ideal Portfolio for Salaried Individual – Aged: 25 to 3
We see that:
- This is a portfolio with a high-risk orientation due to the long-term horizon available;
- The long-time horizon allows us to aggressively allocate significant capital (85%) to Growth Stock Funds, Commodity Funds & Cryptocurrency.
- The idea is to make regular contributions to the portfolio through savings & the fixed income portfolio to gradually build up positions.
Ideal Portfolio for Salaried Individual – Aged: 35 to 44
We can see that:
- Equity and Commodity have less capital allocated to them;
- Fixed income has more capital allocated to it;
- Real estate has capital allocated to it through investment in real estate investment trusts or physical estate;
- Again, the focus here is to consolidate gains from the last period into risk diversification endeavors (45% allocation to fixed income, Commodity funds & real estate) while maintaining a heavy capital growth strategy with a high (55%) allocation to growth stocks and Cryptocurrency.
- Again, we are not concerned with short-term volatility as our investment horizon remains long-term.
Ideal Portfolio for Salaried Individual – Aged: 45 to 54
We can see that:
- With just 15 years or less left to our retirement goal, it is now important to wind down the high-risk elements of our portfolio;
- A passive index tracking fund replaces the Growth Stock fund at a reduced overall allocation;
- Fixed income and real estate have more capital allocated to them;
- Commodity and Cryptocurrency have less capital allocated to them;
- As can be inferred, at this stage the portfolio doesn’t have the luxury of ignoring short-term volatility and is concerned with consolidating gains, protecting against inflation, and targeting capital appreciation in a less aggressive manner.
Ideal Portfolio for Salaried Individual – Aged: 55 to 60
We can see that:
- With retirement approaching, the focus is now increasingly on principal preservation and generation of income to increase the overall portfolio value in a measured way. Hence, 90% of the capital is allocated to fixed income & real estate.
- Some risk allocation remains to equity for a “kick” to overall capital accumulation efforts.
Retirement:
With retirement, there is no need for risky endeavors.
The goal of the portfolio is now to fund his living expenses into retirement. Hence, an equal-weighted portfolio is constructed between fixed-income funds & real estate.
Conclusion
It can be gauged from the above discussion that there is no single answer to the perfect portfolio for salaried individuals.
In other words, the answer will depend on a lot of factors & we may utilize the life cycle analysis as a guideline for building the perfect portfolio for salaried individuals.
Be advised that this is just a framework, as real-world situations may be more complex with multiple goals that may not wait till retirement.
Therefore, I encourage you to seek professional advice for your own portfolio decisions.