Building my Personal Portfolio Part 1: Risk and Expected Return

The biggest risk is not taking any risk

– Facebook Employee

My Portfolio Construction Steps:

  1. Define Risk: Drawdown
  2. Define Portfolio Allocation Weights
  3. Calculate Expected Return
  4. Set your Investment Goal
  5. 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

Be the first to comment

Leave a Reply

Your email address will not be published.


*