How to Build a Portfolio One Brick at a Time

How to Build a Portfolio One Asset at a Time

Beginner, Theory

My single favorite toy as a child really wasn’t a single toy.  It was my giant bucket of LEGO accumulated over many years.  The beauty of LEGO is that the combinations are absolutely limitless and the things you can build with them are constrained only by your imagination.  Well… and access to all the right pieces.

You see, when building a spaceship, race car, or castle it’s sometimes not good enough to have a big bucket of parts.  You need to have the right parts.  The right color for the walls, the right size to fit in a tight space, or the right shape to make a respectable wheel or wing.  Many hours were spent browsing the toy aisle not for the final product pictured on the box, but for just the right part in the kit to add to my collection.  Without the right building blocks, the best designs just aren’t the same.

For a while now Portfolio Charts has been focused on the LEGO kits — the portfolios that you can build for yourself and the calculators to help you do it.  But I’ve known for a while that it’s been missing an important ingredient.  Today I’m happy to unveil brand new section to the site dedicated to the portfolio building blocks themselves — Assets.

The Assets section provides detailed information for every asset class used in the portfolios and calculators.  Each page includes a brief overview, information on the source data, and a reference list of low-cost index funds tracking that particular asset that you can easily purchase at your favorite brokerage.  At the bottom of each page you can find every portfolio on the site that uses that particular asset so you can easily browse how various people have incorporated them into their recommended asset allocations.

In addition, I’ve added a miniature Pixel chart for each asset to help you visually see the shape of the brick — exactly when it did well and when it struggled historically.  I personally find this part particularly fascinating, so let me offer a working example.

People often like to talk about the very long term average returns of individual assets just like they do with portfolios.  Since 1972 the real CAGR of the total stock market is about 5.9% and for gold it’s a measly 2.9%.  Looking only at the long-term averages, a reasonable investor might bust out their calculator and estimate that a portfolio with 60% stocks and 40% gold would have generated a long-term real return of about 4.7% a year over the same timeframe.

So owning gold must be a bad idea, right?  The reality is quite a bit more interesting, and to uncover why we first have to reevaluate an old metric that too many people take for granted and don’t really understand.

Portfolio theorists sometimes like to lecture about asset correlations, but when you boil them down to a single number between -1 and 1 you lose a lot of information and perspective.  You may read that the total stock market and gold had a correlation of -0.24 since 1972, for example, but if you’re like me you probably have a tough time translating that information into something truly actionable.  However, put a time-based heat map of the two assets side by side and the impact of correlation is immediately striking.

When you look at the charts above and see how they got to their long-term averages it’s glaringly obvious that there’s far more to the story.  In the short and mid-term (the realistic time frame for portfolio rebalancing plans), gold has been a near mirror image of stocks.  With blocks that fit so well together, a curious builder might wonder what a portfolio would look like with a bit of both.

60 Percent TSM 40 Percent GLD

Yes, you’re reading that correctly — The real CAGR was a full 1.3% higher than our original estimate.  In fact, adding 40% of a more volatile asset with much lower long-term returns and no interest or dividends actually slightly increased the overall portfolio return over the stock market alone while reducing volatility significantly.  How on earth can this be true?

At this point I could talk about the nuances of correlations, volatility, and rebalancing and how they all affect the math behind buying low and selling high.  Perhaps I’ll explore that in a future post, but for now let me make it really easy.  It works because the building blocks fit so well together.  You can see it in the charts, and it plays out in the math.  Diversification is a powerful tool!

Taking it a step further, gold arguably does a better job complementing stocks even than bonds over virtually all timeframes.  Take a look at a typical 60-40 total stock market / total bond market blend and compare it to the previous chart with gold:

Classic 60-40 Pixel Chart

In addition to the notable differences in red/white zones of stress-inducing low and negative returns, astute observers will also notice that the 60-40 bond portfolio actually had lower volatility (measured in standard deviation) than the 60-40 gold portfolio but with twice the longest drawdown. Raw standard deviation numbers just don’t tell the full story of how a portfolio feels along the way.  How can that be? Let’s look again at the building blocks:

With fewer extremes, the total bond market certainly reduces the overall volatility of a stock portfolio but they’re quite a bit more correlated than many people realize — the best years for both were in the 80’s and 90’s and worst years were in the 70’s and 2000’s.  Stacking those two building blocks alone is sorta like building a LEGO fighter plane with two left wings.  Just because one is a different color or a slightly different shape doesn’t mean the plane is balanced.

Now please don’t get me wrong — there’s much more to building a good portfolio than simply finding assets that perfectly complement each other historically or that look good in a back testing calculator.  I’m definitely NOT recommending that everyone run out and trade all of their bonds for gold.  Economic conditions change all the time and the past is absolutely no guarantee of future returns, so the reasoning for why a portfolio worked and may continue to work is just as important as the fact that it did work.

It’s exactly for that reason that the Assets section is not just about pretty charts and calculators but more fundamentally about asset education.  Think of the charts as visual guides to asset correlation and volatility, but always remember there are other important data points as well.  Assets-Example

My comments on each asset are just scratching the surface and I plan to build on them over time.  Please also follow the links to individual index fund websites not just to compare expense ratios or double-check the index (although you should absolutely do both of those things) but also to read about the assets in more detail — fund managers are generally very good about detailing all of the various risks involved.  And for advanced discussions from a variety of viewpoints, follow the links to the portfolios that use the assets and read the books by the various portfolio authors.  They undoubtedly go into detail about why they chose the assets they did.

If anyone finds an error in the Assets section or would like to make a suggestion, please don’t hesitate to contact me.  I’m certainly not infallible, and the process of putting all of this together has been educational for me as well.  Like the website as a whole, my goal is not to sell anything or to trivialize the layers of work that go into wise asset management but to attempt to explain the concepts in a way that demystifies them and empowers everyday people to take knowledgeable ownership of their own finances.  My sincere hope is that the new Assets section will start you down the road not just of following the advice of others (even my own), but of learning how the building blocks work for yourself.

Happy portfolio building!