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Invest Smarter, Not Harder: What You Need to Know about Modern Portfolio Theory

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Looking for a smarter way to plan for retirement? Nick, Bunker Labs Director, comes on the podcast to answer your biggest investing questions! 

Smarter Investing with Modern Portfolio Theory

I’ve been writing and (now podcasting) about personal finance and over the years I’ve received plenty of questions about money.

One popular topic is retirement.

While it may not be a day to day concern with many couples trying to juggle family, work and more, it doesn’t mean they’re not worried about it.

Today we’re going to answer your big investing questions.

I’m a big believer in educating yourself with finances. No one is going to care about your finances as you do.

Being knowledgeable helps you to protect yourself from making huge money mistakes.

I enjoy learning from others and tapping into their expertise. So to get into the details with investing, I’ve recruited some help – Nick Bradfield, formerly Divvy Investments founder and now Raleigh-Durham's Bunker Labs Program Director.

In this episode we'll get into:

Hope you enjoy!

Investing, Modern Portfolio Theory, & More

If you want to learn about investing, here are some key resources to check out:

Why Diversification is Important as an Investor

Elle Martinez: I met Nick a couple of months ago when he had co-hosted the road to financial wellness pit stop here in the Triangle.

I knew that Nick's personal and professional background would be especially handy with your investing questions.

Nick Bradfield: Jumped into the financial services industry as a traditional financial advisor during the crash.

As a Marine, I saw smoke and ran towards it.

[I] was a traditional advisor for a few years with a large brokerage firm and really got interested in index funds, ETFs, and modern portfolio theory, asset allocation, and really wanted to focus on, on helping the middle class there.

Elle Martinez: I hear diversification is important. Why?

Nick Bradfield: Everybody's heard the phrase. You don't want to put all your eggs in one basket.

A classic example of that is unfortunately, what, what happened, and in the Enron days know where so many people had their retirement savings in their company stock.

And then the blink of an eye, the company stock just kind of evaporated.

You want to be diversified so you can protect yourself. There's always going to be stocks, bonds, and funds going up and down at different times.

And you want to have a good mix. You invest long enough. There are going to be losses, but the goal is that over the longterm, you know, you're able to maximize your returns, but you just want to make sure you minimize your losses in there.

That's why diversification is important.

How Many Stocks Should We Own to Have a Diversified Portfolio?

Elle Martinez: How many stocks do I need to be diversified in my portfolio?

Nick Bradfield: You were just buying a bunch of stocks. You really need to buy at least 20 different stocks in a variety of industries to be diversified, and that can get pretty expensive.

So a mutual fund is, is like a basket full of stocks. It's a way to get diversification in one fund.

[Those] mutual funds are, are what they referred to as actively managed, which means there's a portfolio manager or a team of people that are constantly evaluating the markets and the economy and all kinds of different things and moving in and out of different positions with different companies there.

Constantly doing these big moves of bringing in this stock and selling that stock to do that, that costs money.

So you pay an internal fee or what's often referred to as an expense ratio of, of oftentimes between one and one and a half percent. Sometimes more, sometimes as high as 2%, you don't see it. It just comes out of the fund.

Elle Martinez: If you'd like to keep your fees as low as possible than index funds may be the way to go.

Nick Bradfield: Every one of those mutual funds track. A benchmark or an index fund. So an index fund is like the S and P 500 or something like that. And the S and P 500 and other index funds and exchange traded bonds are very low expense ratios because they're not actively managed.

They're they're passive. So there's not somebody who's constantly jocking in and out of those positions, it's just passive attracts the benchmark. That's it.

Elle Martinez: As counterintuitive as it may seem, index funds can give you an edge with investing, take the fees that adds up and that adds up quickly.

Nick Bradfield: If you think of your investing over 20 or 30 years, not 1% compounding every single year, that is a lot of money at the end of, at the end of the day.

And so that's one reason why I like the next one is just the fees are significantly lower.

Another big thing is that the majority of mutual funds, don't beat the benchmark or index that they track anyway.

So in many cases, you're not always, but in, in many cases, you're overpaying for something that is underperforming.

Understanding Modern Portfolio Theory

Elle Martinez: While it's impossible to create a perfect portfolio that will minimize risk and maximize returns, modern portfolio theory, which Harry Markowitz developed can help you get closer to that goal.

Nick Bradfield: I'm a huge fan of, of modern portfolio theory. It's been around since the fifties, the guy who created it won the Nobel prize in economics for pioneering work and theory of financial economics, a whole bunch of universities use it to manage their endowments.

The whole goal of the concept is to minimize the downside and, and maximize your upside for your risk tolerance.

What it does is it says, Hey, based on your risk tolerance, you should have. X percent bonds, X percent, us stocks, X percent international stocks, and maybe X percent alternatives.

The models that make up modern portfolio theory do is they allocate your money across all those different sections. The ultimate goal is when those get out of balance when you know, you have too much of a percent for your risk in one category and too little in another category.

Then you readjust back to those target percentages.

What's My Risk Tolerance?

Elle Martinez: That's the general concept behind modern portfolio theory, but how do you find your risk tolerance?

It is possible to build a low cost and diverse retirement portfolio. Creating one though means knowing your risk tolerance, but how can I find out what my risk tolerance is?

Nick Bradfield: Million of them out there they're anywhere from they're usually pretty short, you know, 10, maybe 20 questions in it. It asks you a variety of situations.

If this happened, what would you do? How old are you, when do you plan to do use this money? how much of it are you going to be using? That helps identify what your risk tolerance is or what, what you can stomach.

From there, those questionnaires will help you determine what a good asset allocation is for you. So it'll take that, the answers to your questions into account and. Recommend the percentage of bonds and stocks and us and international and all that.

Elle Martinez: The difficult part is if you're new to investing, it can be hard to gauge what yours is because risk tolerance is about how much loss you can deal with in the short term on paper, you may think you can handle a dip, but you have to ask yourself, it feels still keep investing.

When you see a drop it's in your best interest to answer as honestly as possible. You don't want to have an allocation that causes you to panic and move too soon because you can't deal with the short term volatility.

Nick Bradfield: I think that's something that is key to remember.

Just like when we were talking about modern portfolio theory a minute ago, and you mentioned that chart that we discussed, you look at the chart and you see all the asset classes ranked over the last 10 years.

And it's just a whole bunch of colors. There's no pattern there. It's, it's the same way with.

With risk and you know, it's individual, you, there's not a pattern of one size fits all. You should do it this way. So the general rule of thumb, you know, the younger you are, the more time you have. So the more aggressive you can be, but just because your neighbor's doing that doesn't mean that that's the right thing for you.

You may be really conservative and instead of wanting to be more aggressive with your investments, you want to just. Save more and put more into it. It's a very individual thing.

So that's the biggest thing I would recommend when determining your asset allocation is don't be concerned with what your friends and neighbors are doing.

Do what is the right thing for you.

Elle Martinez: However, you invest, make sure you understand what you're getting into.

Hopefully, this episode will jumpstart your retirement planning!

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Music Credit

Like the music in this episode? Our theme song is by Gentle Regime.

Additional music by Lee Rosevere and Logan from Music for Makers in this episode.

This episode was originally released in August 2016. Show notes have been updated in September 2020.

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