Portfolio Perspective

Build a strong portfolio in 7 easy steps

Tim Maurer, special to CNBC.com

Strong ... but simple

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The movement of markets is so incredibly complicated that even the world's most skilled portfolio managers struggle mightily to "beat the market" over the long term. Building a strong portfolio, therefore, must be similarly (and singularly) complex, right? Wrong. While portfolio architecture and management is not easy, here is a seven-step process that makes it surprisingly simple.

— By Tim Maurer, director of personal finance for Buckingham and The BAM Alliance
Posted 14 April 2016

Step 1: Know thyself

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This bit of ancient Greek wisdom is where we must begin, because personal finance is more personal than it is finance. Investing is complex because we are complex. Therefore, we must understand ourselves before we try to understand the markets.

This means honestly gauging your time horizon and the returns necessary to meet your goals. But it's especially important that you understand your willingness to take risk in the markets. You must take the gut-check test.

Step 2: Understand investing

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It's true that you shouldn't invest in something you don't understand, because when times get tough, you're more likely to part with even the best investment strategy if you don't sufficiently comprehend the logic behind it. My colleague, author Larry Swedroe, says in his unmistakable New York accent, "You oughta be able to explain your investment strategy to a fifth- grader."

You should be familiar with the compressed history of "the market" and work to become conversant in the foremost systematic, academic approach to market investing: Modern Portfolio Theory.

Step 3: Design your portfolio

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Once we've acquainted ourselves with ... well, ourselves (as well as the fundamentals of markets and investing), it's time to build our portfolio. I've created a simple starting point for investors that synthesizes the essentials of Modern Portfolio Theory — by diversifying across a broad cross-section of equity asset classes, favoring those that have historically outperformed — and a basic understanding of behavioral finance, by reducing portfolio volatility through the anchor of conservative fixed income.

Refer back to Step 1 to determine if this balance of stocks and bonds is appropriate or if it should be calibrated more aggressively (by increasing the allocation to stocks) or conservatively (by increasing the bond allocation).

Step 4: Implement your portfolio

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OK, now you've got the knowledge and the plan, but all of that is worthless if you don't actually translate it into action. Because we have no control over market fluctuations, we must focus on controlling the factors that we can. Chief among these is the cost of investing.

I recommend avoiding commission-sold mutual funds and "actively" managed funds with higher internal expense ratios, favoring instead no-load, "passive" or indexed funds in your corporate retirement plans, self-managed accounts and accounts under the stewardship of a financial advisor.

Step 5: Monitor your portfolio

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You want to be cognizant of what's happening in your portfolio but not obsessed about it, because paying too much attention to your portfolio usually works against you. Yes, certain actions may be advisable when markets move — see Step 6 — but making major changes midstream typically hurts more than it helps. And if you absolutely must, when it's appropriate, "get out of the market," click here.

Step 6: Rebalance your portfolio

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Especially in times of significant market volatility, the inevitable question arises: "So, I'm just supposed to sit here and watch my portfolio get clobbered?" No, you need not sit idly by. If the market has moved enough that you're getting a nervous feeling in your gut, chances are good that your portfolio is out of balance.

In such cases, it's entirely appropriate to bring your portfolio allocation back to its starting point through the act of rebalancing. While rebalancing has not necessarily proved to "make you more money over time," it does help reduce overall portfolio volatility.

Step 7: Fund your portfolio

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Too often, we seek to blame others — perhaps a spouse, investment managers or even the markets — for having too little in our portfolios. But while any (or all) of those parties may share in the blame, don't forget that we — YOU — are the primary determinant of your investment success through the contributions you make.

How your portfolio is structured absolutely is important (and that's the focus of this article), but the biggest factor for success in investing is not the nuance of your portfolio management style but your willingness to persistently save a meaningful portion of your hard-earned income. This ensures you can recreate your income at some point in the future when you're unwilling or unable to do so.