The biggest risk is not taking any risk
– Facebook Employee
My Portfolio Construction Steps:
- Define Risk: Drawdown
- Define Portfolio Allocation Weights
- Calculate Expected Return
- Set your Investment Goal
- Calculate Monthly Contributions
Step 1: Define your risk
- Drawdown is defined as follow: how much an investment or trading account is down from the peak before it recovers back to the peak (Credit: Investopedia)
- To illustrate my portfolio building I will select a risk asset (SP500 Equities) and a risk free asset (Canada Fixed Income Index)
- In my opinion, drawdown the best measure of risk as it (a) Tells me how much I can loose in the worst case scenario (b) Easy to understand
Table 1: Drawdowns of US Equity Indices (Descending)
| Drawdown Value | Drawdown Start | Full Recovery | Months to Recover | Months to Bottom |
|---|---|---|---|---|
| -85% | September 1929 | August 1954 | 299 | 33 |
| -51% | October 2007 | February 2013 | 64 | 18 |
| -47% | June 1872 | January 1880 | 91 | 61 |
| -44% | August 2000 | April 2007 | 80 | 30 |
| -43% | January 1973 | June 1980 | 89 | 23 |
| -42% | June 1881 | November 1900 | 228 | 182 |
| -38% | September 1906 | July 1909 | 34 | 14 |
| -37% | December 1909 | December 1924 | 180 | 140 |
| -29% | September 1902 | February 1905 | 29 | 13 |
| -29% | December 1968 | February 1972 | 38 | 17 |
| -27% | August 1987 | June 1989 | 22 | 4 |
| -22% | December 1961 | August 1963 | 20 | 7 |
| -20% | December 2019 | June 2020 | 6 | 3 |
| -19% | November 1980 | October 1982 | 23 | 19 |
| -17% | January 1966 | July 1967 | 18 | 8 |
| -17% | July 1956 | August 1958 | 25 | 16 |
- I am not comfortable loosing 50% of my portfolio, and thus I cannot allocation all of my portfolio to equities
- Decision 1: My targeted maximum loss for my retirement portfolio is 35% from its peak
Step 2: Define portfolio allocation weights
• it is common for equities to loose 50% of their value. Similar drawdowns occurred in 2000 and 2008.
• If my maximum loss is 35%, then my allocation to equities (or risky portfolio) can be defined by the following formula
Allocation to Equities = 100*Maximum Loss/Maximum Drawdown
Allocation to Equities = 100 * 35%/50% = 70%
Note: the drawdown calculation assumes no currency risk/exposure (more on that in part 3)
Decision 2: Allocate 70% of my portfolio to equities and 30% to Fixed Income / or inversely correlated asset
Step 3: Calculate my expected return given 35% maximum drawdown risk
- to limit my drawdown risk to 35%, I need to allocate 70% to equities and 30% to a fixed income ETF (or or inversely correlated asset with positive long-term return)
- Historical return on equities has been approximately 10%/year
- For fixed income, most portfolio indicate a very low yield to maturity of 1%.
- My expected return before fees can be calculated as follows:
Expected Return = Weight (Equities) * Return (Equities) + Weight (Fixed Income) * Return (Fixed Income)
Expected Return = 0.7 * 10% + 0.3 * 1% = 7.3% (per year)
In other words, a 70/30 portfolio should have a maximum drawdown risk of 35%, and an expected return of 7.3%/year
Step 4: Set your goal
- my retirement goal is to have $1,000,000 in 20 years. Because of inflation, I set my goal to a more conservative 1.64 MM (This assumes 2.5% inflation rate over 20 years)
- This goal is conservative, because I will need to increase my monthly contributions to reach this goal
Decision: set my retirement goal to 1.64 MM in nominal terms
Step 5: Calculate my monthly contributions
- We use PMT formula in Excel to calculate our monthly contributions to reach 1.6 MM goal
Monthly Contribution = $2,083.14 / Month
WoW!
Here is a summary of my calculations:
Calculate Time Horizon to Goal
Years to Retirement: 20 Years
Current Retirement Portfolio: $120,000
Future Retirement Portfolio: $1,640,000
Return (after fees) 7%
Required Contributions: $2,083.14 Monthly into a 70/30 portfolio
Risk Level: 35% Maximum Drawdown
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