How to Build Your Investment Portfolio

(***This blog is part of our 4-part Podcast series on investing, and is best understood when combined with "Episode 007 Investing 201" of the Service and Wealth Podcast on Spotify or Apple Podcasts.***)

Building wealth is not just about saving money; it’s about making smart investment decisions that ensure your financial growth and security. And one of the most important parts of your investment plan is how you choose to "diversify" your investments. If you've already started investing (and even if you haven't started), you've no doubt heard people talk about "diversification", but what is it, why does it matter, and how does it help with your returns and the security of your investments?

Diversification is when you invest in different types of assets (stocks, bonds, crypto, options, real estate, gold, etc.) in order to lower the risk of losing a lot of money if the market for one or two of those things goes bad. This is the investing version of the old adage warning you "don't put all your eggs in one basket." In a real-world scenario, think of it like this: if you had $100 to invest and invested it all in Enron in June 2000, you would have started out pretty great. But then in December 2001 when Enron went to $0, you would have lost it all. If you had invested only $50 in Enron and put the other $50 in Google, you would have still lost $50 -- but not all of your money.

That's the lowest level of diversification you can have: owning two stocks. But it applies at just about every scale you can think of. If I invest in the S&P 500 through my TSP C Fund, I own 500 different stocks and am even more protected from getting burned by an Enron-like implosion. In the S&P 500 there are 11 different sectors from Oil & Gas to Information Technology (IT). So not only do I have security against bad single stocks like an Enron, but I am also diversified across the whole economy. If AI stocks have a mini-crash, my investments will lose some money, but they will be held up by solid stocks in other sectors like Coca-Cola, Johnson & Johnson, Lockheed-Martin, or ExxonMobil.

But in the "big picture" if there is a stock market crash, I could still end up losing a lot of money. So when it comes to the concept of "diversification" of your investments, what we're talking about is not being totally invested in just the stock market. You have to own other things like cash, bonds, options, crypto, or real estate. If the stock market goes down, maybe crypto goes up or real estate holds steady, and in this way you make sure that you can keep making profits.

The most common strategy is to mix stocks and bonds to do this, and the age-old debate has been how much of your money to invest in bonds because the more you invest in bonds the lower your returns. It's typically a trade-off between risk and return. But what if I told you that traditional diversification isn't good enough and you don't need to give up returns for security. What if I told you that "true" diversification can protect you against big losses (lower your risk) and also actually get you higher returns? Imagine lower risk and higher returns -- how is that even possible?

The Problem with Traditional Diversification

The argument is that bonds are more "stable" and less likely to have the big swings of the stock market, so they are "safer." Over the past 100 years, stocks have been more than 2x as volatile as bonds, with yearly swings from -40% to +40% compared to -18% to +32% for bonds. To smooth out the big swings of stocks, traditional investment strategies invested in bonds. But it doesn't always help. Consider 2022: the U.S. stock market lost 19.4% -- and the U.S. Bond Market lost 17.8%! If you invested in bonds to "protect you against loss" you didn't gain much at all!

What's more is that over the same 100-plus years the stock market has averaged a 10.8% return per year while the U.S. Aggregate Bond Index has averaged 5.5% per year over the same period. That means traditional diversification drags your returns down-down-down, and if your returns go down too far you will not reach your savings goals. You need to target an average yearly return of 8% adjusted for inflation, or 9.2% overall. That puts a floor on how much of your portfolio can be invested in bonds, which happens to be 30%.

• A 70% Stock + 30% Bond portfolio nets 9.2% on average, or 8% adjusted for inflation
• A 60% Stock + 40% Bond portfolio nets 8.8% on average, or 7.7% adjusted for inflation (note the increase in bonds increases your dividends, so your total return doesn't drop the full 0.4%)

How would this look in your TSP? If you have $10,000 in your TSP, you would want to have $7,000 in the C Fund and $3,000 in the F Fund. At the end of each year, you would then have to remember to adjust your allocations to make sure you don't drop below 70% C Fund.

That can get a little messy with math and remembering to do it, and can be a bit intimidating. It would obviously be easier to just invest 100% of your TSP in the C Fund. If you did, you would net 10.8% on average, and after adjusting for inflation, fees, and dividends come out at 9-9.5% per year. You would beat your 8% target, and be able to retire with more money, or earlier.

 But that doesn't fix the problem of risk and security, and you still need diversification. Does that mean all hope is lost and you need to bite the bullet and still invest in the F Fund and do math to balance your portfolio each year? Not at all!

A Complete Picture

When you're considering how to diversify your investments, you don't just think of the money in your TSP and diversify there, then look at your E*Trade account and diversify there, etc. You need to look at all of your savings and investments: everything you have is your portfolio. In fact, when you realize you need to include everything, you already have some pretty good diversification because you also have some very safe cash savings, may own your home, etc.

To visualize this, let's look at an example of a service member who has $100 in assets across all of their accounts:

• $15 in their Emergency Savings Fund
• $15 saved to buy a home using the VA Loan
• $10 invested in a Vanguard account
• $60 invested in their TSP

As it stands, this service member has $30 in cash savings (in High Yield Savings Accounts [HYSA] of course!), so assuming all of their Vanguard and TSP investments are in stocks only, they are already diversified with 70% in stocks and 30% in non-stocks. That $30 in cash savings is virtually risk-free and is insured against loss by the Federal Deposit Insurance Corporation (FDIC), meaning this person has all the diversification they need for security of their portfolio. When you consider most HYSAs today pay 5-5.5% interest, the return on those is basically the same as the F Fund or a Vanguard mutual fund investing in the Aggregate Bond market.

This service member should absolutely avoid investing in bonds, and their TSP should stay 100% invested in the C Fund in all circumstances.

The Power of "Alternatives"

Since cash savings in an HYSA pay interest at the same rate as the long-run average return of bonds, but without any risk at all, you should consider a strategy that uses your HYSA savings to replace bond investments altogether.

In addition to the great interest rate on the HYSA and the zero risk, the money in your HYSA is also easily accessible (liquid) and can be withdrawn without worrying about creating a "taxable event". If you invested $100 in bonds, let the investment grow to $120, then sold it to use the $120 to buy an investment property, you would have to wait for markets to open and your Vanguard brokerage to process the order, sell the shares, settle your account, and transfer the net amount back to you. You may also owe taxes on the $20 profit. 

With the bond question ruled out, to truly diversify your portfolio, you will now need to think outside the box and include alternative investments. "Alternatives" include real estate, Real Estate Investment Trusts (like a mutual fund for investing in real estate without owning an actual house), futures contracts, hedge funds, currencies, gold, crypto, and other non-stock/non-bond/non-cash assets. Alternative investments, particularly real estate, can provide substantial benefits that traditional assets cannot:

1. Lower Risk. Unlike bonds, alternatives like real estate often behave differently from stocks and bonds. In a year like 2022 when bonds and stocks lose value, real estate across the U.S. increased in value by an average of 15%.
2. Higher Returns. Historically, real estate investments have offered competitive returns thanks to being able to use leverage (mortgages) to buy real estate. Because of this, when you combine average rates of appreciation with rental income, the typical real estate investment will average 15-20% returns per year.
3. Inflation "Hedge". Because real estate and physical investments like commodities, including gold, silver, food, etc. is purchased with cash, values increase proportional to inflation, regardless any ups or downs in the market. While dividends you can earn on stocks and bonds depend on the stock performance, rent you earn from real estate investments will go up with inflation, ensuring you are always staying ahead.

The Ideal Allocation

Thanks to research by the biggest investment research and ratings firm Morningstar, we now know that a 20% allocation in your portfolio to "alternatives" will not only lower your risk by 5-10%, it will also boost your returns by 1-1.5% per year. This holds true whether you have 100% invested in stocks, 100% in bonds, or a 50:50 stock:bond(cash) mix.

The benefit of this is that you can now create an investment portfolio that is better than a traditionally diversified stock-and-bond portfolio because instead of swapping high-flying stocks for low-paying bonds, you can swap for equally solid returns of real estate and other alternatives. Because bond returns average 5.5% you couldn't drop below 70% stocks if you wanted to keep your total return to 8% or better. With alternatives, you no longer have to keep your stock holdings above 70%. Returning to our earlier example of a $100 portfolio, it might now look like this:

• $20 in HYSA (Emergency Savings + other savings, for example for a new car)
• $20 invested in a house
• $10 invested in a Vanguard account
• $50 invested in their TSP

This service member's overall portfolio is now just 60% stocks -- in a stock-and-bond portfolio, that would drive their returns down to 7.7%. But by swapping cash in an HYSA for the bonds and adding real estate as an alternative, they will actually increase their expected average annual return to 9% or better while benefitting from even more stability and less risk than if they had bonds.

Practical Steps to Build Your Portfolio

You don't have to invest in real estate and own property, but you do need to change your thinking from the traditional ways of "diversification" and start using alternatives to replace bonds. Over the course of your investing life, you don't even need bonds or alternatives at the start because your cash savings in High Yield Savings Accounts serve the role brilliantly. Once you establish a strong financial base with sufficient retirement savings in your TSP and enough cash in your Emergency Savings Fund, it will be time to start saving for and investing in alternatives:

1. Hold Steady. Continue to save for retirement and make consistent monthly deposits and investments in stocks (C Fund in the TSP, for example) according to your plan. Don't abandon stocks as a main part of your portfolio.
2. Use HYSAs Extensively/Exclusively. Find banks that offer HYSAs paying 5% or more in interest, and move your money there. So long as your cash is not sitting in a regular checking or savings account paying 0-1% interest, this strategy will work.
3. Set Total Portfolio Goals. As you save cash in an HYSA to purchase real estate or make other alternative investments, you have time to research and update goals and strategies. Compare different alternative investments and pick the one that feels right to you.
4. Concentrate. Once you've picked the alternative you like, commit to that. Try not to spread yourself too thinly and invest in all of them.
5. Educate Yourself. Study your preferred alternative asset as much as you can. Knowledge is power, and once you have the cash to get going you want to have the confidence to start.
6. Invest. Trying to time the market is almost impossible. You aren't investing to make a quick buck overnight, but for the long term of 5, 10, or 20 years in the future. At those scales, it won't matter if you lost 10% in your first year from unlucky timing, so don't try to wait for an "ideal" moment to start. As they say in real estate, "the only better time to start investing was yesterday."
7. Monitor and Adjust. Regularly review your portfolio and make adjustments as needed. Set limits on how much of a loss you're willing to take before selling, and dump the losers that aren't performing. Over time you will find your portfolio is packed with winners, and is growing by double digits each year, fast-tracking you to Financial Freedom.

Conclusion

Building a truly diversified investment portfolio means going beyond the traditional stock and bond allocation. When you read, see, or hear professional Financial Advisors, influencers, and the traditional retirement planners encourage you to buy bonds, remember that they're the ones who also manage and own the bonds, and profit off your investments in bonds just as they do from stocks. Believe in the data and think for yourself so you can stay in control of your financial destiny and not surrender it to chance or some self-interested broker or money manager.

By including alternative investments like real estate, considering cash and cash equivalents, and maintaining a significant portion of growth assets, you can create a portfolio that is superior to a traditional stock-and-bond mix. Not only will you have better stability and protection against the risks that infect stocks and bonds at the same time, you will also boost your returns.

Challenge the traditional notions of diversification, and take control of your financial future today. With the right strategy, you can achieve financial freedom and enjoy the lifestyle you desire.