Portfolio Construction Case Studies – The White Coat Investor – Investing & Personal Finance for Doctors

I have tried over the years to teach the principles of basic portfolio construction, with varying levels of success. Part of the issue is that most people only ever do it once and even a high-quality financial advisor may only do it 50-100 times in their life. The process involves various tasks of account selection, asset allocation, asset location, and investment selection. New Do It Yourself (DIY) investors often find the task overwhelming, so much so that they are willing to pay someone thousands of dollars to do it for them. Rather than going over the principles of portfolio construction (again), I thought that perhaps today we’d take a different angle and just go through a few completely made up case studies to illustrate the relevant principles.

The 6 Steps of Portfolio Construction

If I had to list out the steps you must take to successfully construct a portfolio, I would list them like this:

1. Financial planning
2. Gather information
3. Account selection
4. Asset allocation
5. Asset location
6. Investment selection

In the case studies today, I am going to assume that folks have already completed Steps 1-4. So let me very briefly describe what one needs to do to complete each of these steps.

Step 1 Financial Planning

This is where you put together an insurance plan (disability, liability, health, property, life, etc), a student loan plan, an estate plan, an asset protection plan, and a budget. You have also determined your financial goals and approximately how much you will save each year toward each goal.

Step 2 Gather information

First, gather information about yourself. What is the total of your assets and your liabilities? What is your savings rate? What are your marginal and effective tax rates? What accounts are your investments currently in, what are your current investments, and if in a taxable account, what is the basis on those investments?

Second, gather information about your employer-provided accounts. Which accounts do you have, which ones have a match, what do you have to do to maximize it, and what investment options are available in it? Among those options, what assets do they invest in, what is the strategy of the funds, and what are the expenses of the funds?

Step 3 Account Selection

A lot of people struggle to differentiate accounts and investments. Think of accounts as luggage and investments as clothing. Any type of clothing can go into any type of luggage, but you use different luggage (and clothing) for a backpacking trip versus a 3-week Antarctic cruise versus an overnight business trip. While it is often relatively simple to choose appropriate accounts for a given investment goal (such as a 529 for college savings or a taxable account for saving up a down payment) sorting through the various retirement accounts can be tricky.

The general rule is to use whatever tax-advantaged accounts you have available and then invest whatever else you need to in a taxable (aka non-qualified or brokerage) account. If you use a high deductible health plan, invest in the Health Savings Account. Most high-income professionals and their spouses should be using Backdoor Roth IRA accounts. You can use your employer or partnership provided retirement accounts (401(k), 403(b), 457(b), 401(a), cash balance plans, SIMPLE IRA, etc). If self-employed, you can get an individual 401(k) and even your own personal cash balance plan.

And of course, anyone can invest an unlimited amount in a taxable account. But if you’re planning to save $80K for retirement each year, you can put $19K into a 401(k), your employer matches $10K, you and your spouse each do $6K Backdoor Roth IRAs, that leaves you $39K/year to invest in taxable.

Step 4 Asset Allocation

One of the biggest struggles that beginning DIY investors have is deciding on an asset allocation, i.e. the mix of different types of investments in your portfolio.

Should I have 20% bonds or 30% bonds?

Do I need a cash allocation?

How much of my stocks should be international?

Should I “tilt” the portfolio to REITs or small value or something else?

Do I need rental real estate?

Do I use the full value of the income property or only the equity in making my calculations?

What about commodities, gold, bitcoin, or beanie babies?

The dilemma here is that there is no right answer to any of this. In fact, there may not even be a right answer for you. There are likely dozens of different portfolios out there that would work for you. It reminds me of that eternal question about marriage — Is there one Mr. Right out there or would you likely be happy with any of dozens of different long-term partners? Any reasonable portfolio when combined with the proper temperament and an adequate savings rate is likely going to be sufficient to reach your goals. However, it is also true that there is no more important portfolio consideration than asset allocation! What a Catch-22!

Many financial authors and bloggers have come up with a recommended portfolio –Taylor Larimore, Andrew Hallam, William Bernstein, Harry Brown, Paul Merriman, and Allan Roth to name a few. They’re obviously not all right. Or maybe they are all right, and that’s the point. But I’ve never done that because I find it intellectually dishonest to pretend that I know that one reasonable asset allocation is going to be better than another reasonable asset allocation. I don’t know and knowing basically requires a functioning crystal ball. The goal here is to avoid what I call an “Extreme Portfolio.” If you want to look at a bunch of reasonable portfolios, here is a list of 150 of them, but there are literally hundreds more.

At any rate, if you want to design a portfolio, you’ll need to come up with a reasonable allocation that you believe in and can stick with for a long time. Steps 5 and 6 are generally done together due to the fact that investment selection is often limited by availability of investments in employer-provided retirement plans.

The Case Studies

Let’s get into the case studies. It would have been fun to do this with real live investor portfolios, but let’s be honest, those asking for advice have rarely done Steps 1-4 correctly before coming to me and even if they have, they rarely share the answers. So I’m going to make them up for three hypothetical, but realistic, white coat investors.

Investor Number One — Molly

We’re going to call our first investor Molly. Molly is a 35 years old single internist making $250,000 per year, She would like to retire in 20 years and wants some help with constructing her portfolio. She has her student loans paid off and is working toward paying off her mortgage. She also already has $120,000 saved up for retirement in the various accounts listed below:

• 401(k): 70,000 (58%)
• 457(b): 30,000 (25%)
• Roth IRA: $20,000 (17%)

She has spent a fair amount of time thinking about asset allocation, and has decided she wants to keep it pretty simple. She was going to use a three-fund portfolio (US Stocks, International Stocks, US Bonds) but feels like there would be some benefit to overweighting REITs and adding TIPS to the portfolio and she is willing to deal with that complexity. She does not want to be a landlord and doesn’t trust any of the newer real estate investment companies out there. She thought about factor investing but decided that she really isn’t sure which if any factors are actually real. She settles on the following allocation:

• US Stocks: 35%
• International stocks: 20%
• US Bonds: 25%
• TIPS:10%
• REITs: 10%

She wishes to save 20% of her income ($50,000) for retirement. She took a look at the accounts her employer offers. There is a small match in her 401(k) (50% of the first $10,000 she puts in there) and her 457(b) has reasonable investing options, reasonable distribution options, and she thinks the company will be very stable for decades. So she has decided to split her $50,000 in savings each year in the following manner:

• 401(k): $29,000
• 457(b): 15,000
• Roth IRA: $6,000

While disappointed she cannot afford to max out her available retirement accounts each year, Molly is also glad that all of her retirement savings can be in tax-protected accounts. Since she is in her peak earnings years and really isn’t a super-saver, she elected to use the tax-deferred option in her 401(k). There is no Roth option in her 457, so that was not an issue. She decided that while she would rather use the 457(b) than invest in taxable, she wanted to max out the accounts she really owned (i.e. the Backdoor Roth IRA) first.

Her Roth IRA is at Vanguard, so Molly has a plethora of low-cost options for her desired asset allocation there. She took a look at the 401(k) and found it full of mostly actively managed stock and bonds funds. There was a low-cost S&P 500 index fund with an expense ratio of 0.10% and a good track record of matching the index. There was also two actively managed bond funds, one with an expense ratio of 0.8% and one with an expense ratio of 1.0%. There was one Vanguard fund in the 401(k), the international value fund with an expense ratio of 0.38%, but there were no REIT or TIPS funds in the 401(k). There were two other international funds, but they had expense ratios over 1.2% and short-track records.

She was surprised to learn that she had a totally different line-up of funds in the 457. For some reason, it was held through Fidelity. All of the Fidelity Freedom Target Date funds were available, but they also had the three main low-cost Fidelity Index Funds  — Total Market Index Fund, International Index Fund, and US Bond Index Fund. In addition, the Fidelity Inflation-Protected Bond Index Fund (TIPS) was in there. She decides to “roll her own” portfolio with the index funds in there rather than use the target date funds due to their higher expense ratios and the fact that they don’t mix well with the other funds she will need to get her asset allocation.

Since there are no REITs available in either employer-provided accounts, she has decided to place those in the Roth IRA. So what does her portfolio look like?

• 401(k): 70,000 (58%)
  • S&P 500 Index fund $42,000 (35%)
  • Vanguard International Value Fund (20%)
  • 0.8% ER actively managed bond fund $3,000 (3%)
• 457(b): 30,000 (25%)
  • US Bond Index Fund: $18,000 (15%)
  • Fidelity Inflation-Protected Bond Index Fund: $12,000 (10%)
• Roth IRA: $20,000 (17%)
  • Vanguard REIT Index Fund: $12,000 (10%)
  • Vanguard Total Bond Market Fund: $8,000 (7%)

Five asset classes and six funds across three accounts. Most of that was pretty straight forward. The US stocks fit well with the only index fund in the 401(k). The REITs are obviously in the Roth IRA. There isn’t room there for the TIPS, but luckily the 457 has a TIPS fund, so they can go in there. The international value fund isn’t ideal for someone who really didn’t want a factor tilt, but the expense ratio is so much less than the other international funds in the 401(k) and the 457 and Roth IRA are being mostly used for other asset classes, so a compromise must be made somewhere. The US Bonds are spread across all three accounts. This allows for a relatively easy rebalancing of the portfolio.

Are there other ways this portfolio could be reasonably built given those constraints? Perhaps, but this is certainly reasonable. Some might complain that bonds were put in the Roth IRA. I’ve addressed that issue elsewhere, but if that really bothers you, then you could hold more of the actively managed bond fund in the 401(k) and add the total international fund to the Roth IRA. That would also have the benefit of a more diversified and lower cost international stock holding. This portfolio should “age” pretty well given the ratios of new additions in each account but perhaps in 5-10 years, she may find herself gradually moving an asset class from one account to another. More likely, Molly will end up at a different job with different employer-provided accounts to deal with.

Investor Number Two — Deshawn and Aaliyah

This early 40s dual professional couple has a far more complex financial situation. Deshawn is a partner anesthesiologist making $450,000 per year. Aaliyah is an employee dentist making $150,000 per year, for a total household income of $600,000. They are around 40 and already have a seven-figure portfolio, paid off student loans, and a paid-off house. The current portfolio looks like this:

• His 401(k)/Profit-Sharing Plan $380,000 (35%)
• His Defined Benefit/Cash Balance Plan: $140,000 (13%)
• Her 401(k): $110,000 (10%)
• His Roth IRA: $42,000 (4%)
• Her Roth IRA: $42,000 (4%)
• Taxable account: $386,000 (35%)

Aaliya is the financial brains of the family and so has put a lot of time and effort into asset allocation. After reading a bunch of books, she was heavily influenced by Paul Merriman and his factor-tilted portfolios. However, Deshawn gets a lot of his news from Zerohedge and demands that they have some gold in the portfolio. He also did well with Bitcoin back before they got married (he used the profits on the wedding ring and an Audi) and wants to include some of that. She was able to get him to agree to limit gold to 5% of the portfolio and Bitcoin to 2%. When she first drafted it up, she found there were 15 asset classes in the portfolio. Knowing The White Coat Investor said having more than 10 was just silly, Aaliyah consolidated a bit and ended up with this asset allocation:

• US Large Stocks: 20%
• US Small Cap Value Stocks: 10%
• REITs: 10%
• US Bonds: 20%
• International Large Stocks: 12%
• International Small: 7%
• International Small Cap Value: 7%
• Emerging Markets: 7%
• Gold: 5%
• Bitcoin: 2%

They are pretty good savers and plan to save $150,000 per year toward retirement in the following amounts:

• His 401(k): $56,000
• His DBP: $15,000
• Her 401(k) (including match): $24,000
• His Roth IRA: $6,000
• Her Roth IRA: $6,000
• Taxable account: $43,000

Deshawn’s 401(k) has tons of great investing options including Vanguard and DFA options. There is a low-cost passively managed fund for each asset class they wish to hold, except for emerging markets, Gold, and Bitcoin.

His defined benefit/cash balance plan actually allows him to select the fund it is invested in, but he is limited to one of three Vanguard Life Strategy Funds — Income, Conservative Growth, and Moderate Growth.

Aaliyah’s 401(k) is crappy. She goes through all 20 funds in the plan, looking at the asset classes they invest in, their expense ratio, and their track record against an appropriate index. The 401(k) is so bad she wonders if it is even worth using because all of the funds have expense ratios of at least 0.7% and most are over 1%. All are actively managed. She plans to talk to the clinic owner about it, but for now, she has identified a US stock fund with reasonable long-term performance with an expense ratio of 0.7% and the PIMCO Total Return Bond Fund (ER 0.89%) as possible options for inclusion in the portfolio.

The Roth IRAs and the taxable account are held at Fidelity. While there could obviously be tax consequences for changing holdings in the taxable account, due to a recent downturn, the value of the account is pretty close to basis. They’ve been carrying enough losses forward each year from DeShawn’s stock-picking days that they can invest how they like in that account except for one holding — $50,000 of Apple Stock with a basis of just $20,000 that he was gifted by his still-living grandfather a few years ago.

Aaliyah laid the portfolio out like this:

• His 401(k)/Profit-Sharing Plan $380,000 (35%)
  • Vanguard Total Stock Market Index Fund (3%)
  • Vanguard Bond Market Index Fund (5%)
  • Vanguard FTSE All World International Small Fund (7%)
  • DFA Small Cap Value (10%)
  • DFA International Small Cap Value (7%)
  • Vanguard REIT Index Fund (2%)
• His Defined Benefit/Cash Balance Plan: $140,000 (13%)
  • Vanguard LifeStrategy Moderate Growth (13%)
• Her 401(k): $110,000 (10%)
  • PIMCO Total Return Fund $110,000 (10%)
• His Roth IRA: $42,000 (4%)
  • Fidelity Real Estate Index Fund $42,000 (4%)
• Her Roth IRA: $42,000 (4%)
  • Fidelity Real Estate Index Fund $42,000  (4%)
• Taxable account: $386,000 (35%)
  • Fidelity Zero Total Stock Market Index Fund (12%)
  • Fidelity Zero International Index Fund (9%)
  • Fidelity Emerging Markets Index Fund (7%)
  • SPDR Gold Trust (GLD ETF): (5%)
  • Bitcoin (2%)

The trickiest part was figuring out what to do with that cash balance plan. She thought about just ignoring it and leaving it out of the portfolio for the sake of simplicity but in the end decided to include it, just dividing it into its respective asset classes (36% US stocks, 24% International stocks, and 40% Bonds). The international bond component in the fund is so low she just lumps it in with the US bond allocation the portfolio. So of the 13% of the portfolio in the cash balance plan, 5% is US Stocks, 5% is in Bonds, and 3% is in International Stocks.

Again, the small Roth IRAs were relatively easy and she elected to keep her crummy, little 401(k) simple. So it really came down to what goes in his 401(k) and what goes in the taxable account. Well, it was easy to put EM, Gold, and Bitcoin in taxable since they weren’t options in the 401(k). Total stock market index funds are notoriously tax-efficient, so that makes for a good taxable holding. However, broadly-diversified international index funds like a total international index fund also make for a great holding. While not quite as tax-efficient as a US index fund due to its higher yield, it does qualify for the foreign tax credit which helps make up for it. Another reasonable option would have been to put some of the bonds in taxable as a muni bond fund, but given the great bond option in the 401(k) and recently rising interest rates, she opted to keep bonds in tax-protected.

While Deshawn thought maybe they needed at least a little bullion in their safe at home, they put most of their gold position into the ETF GLD. The Bitcoin was also kept in the fire-safe on a hard drive rather than on an exchange given security concerns.

Overall with 10 asset classes and 14 funds in 6 different accounts, it’s far more complex than Molly’s portfolio, but it certainly is put together well.

Investor Number Three — Gaurav and Uma

Our third investor is a married couple, Gaurav and Uma, who just retired. Gaurav is a retired pediatrician so they’re in a fairly low tax bracket now. Uma was mostly a stay at home mom but worked for Fortune 500 companies at times during her career and so acquired a bit of a 401(k). They inherited a bit of money (and a lot of gold jewelry they liquidated) from her parents a few years ago too, which, when combined with a single paid-off rental property, is the source of their taxable account. They don’t anticipate any paid work going forward (and so have rolled all of their work accounts into IRAs at Vanguard) but will be doing some small Roth conversions each year over the next 6 years or so until they start taking Social Security.  They will be starting to withdraw from their portfolio this year and plan to take out about 4% a year of the mutual fund portfolio, adjusting as they go for portfolio returns. Their accounts look like this:

• His traditional IRA: $1,100,000
• Her traditional IRA: $220,000
• His Roth IRA: $120,000
• Her Roth IRA: $40,000
• Taxable Account: $520,000

Gaurav thinks DIY investing is cool, but Uma plans to use a financial advisor if anything ever happens to Gaurav, so they ran his plan by a young advisor they found on The White Coat Investor Recommended Advisor List who approved it and agreed to be available in the years to come for second opinions and in case of tragedy. This is his desired asset allocation:

• US Stocks: 25%
• International Stocks: 10%
• Real Estate: 10%
• Small Value Stocks: 5%
• Nominal bonds: 20%
• TIPS: 20%
• Cash: 10%

The big question for these folks is dealing with that rental property. It is paid off, cash flows well, is minimal hassle due to their top-notch manager, and has a long-term tenant so they plan to keep it indefinitely. It is currently worth $160,000. The other issue they will deal with over time is a shrinking taxable account and growing Roth IRAs as they do Roth conversions the next few years. Gaurav lays out the portfolio like this:

• His traditional IRA: $1,100,000
  • Vanguard Total Stock Market Index Fund: $120,000 (6%)
  • Vanguard REIT Index Fund: $40,000 (2%)
  • Vanguard Small Value Stock Index Fund: $100,000 (5%)
  • Vanguard Intermediate Term Bond Index Fund: $400,000 (20%)
  • Vanguard Inflation Protected Securities Fund: $400,000 (20%)
  • Vanguard Prime MMF: $40,000 (2%)
• Her traditional IRA: $220,000
  • Vanguard Total Stock Market Index Fund: $22,000 (11%)
• His Roth IRA: $120,000
  • Vanguard Total Stock Market Index Fund: $120,000 (6%)
• Her Roth IRA: $40,000
  • Vanguard Total Stock Market Index Fund: $40,000 (2%)
• Taxable Account: $520,000
  • Total International Stock Market Index Fund: $200,000 (10%)
  • Vanguard Prime Money Market Fund: $160,000 (8%)
  • Rental property: $160,000 (8%)

This portfolio is a thing of beauty. This will be so easy to manage it isn’t even funny. Almost all of the rebalancing will be done in one account, his big IRA. As the Roth conversions happen and more US stocks go into the Roth IRAs (and the taxes are paid by the taxable cash), the total stock market fund in his IRA will be exchanged to Prime MMF. The only asset class not in the traditional IRA is the international stocks, but you could even put some of that in there (and some US stocks in taxable) if you wanted to. Should you put the total international fund into taxable before the total stock market fund? Well, the jury is still out on that subject, so the truth is that if one set-up is better than the other, it isn’t by much. If the property appreciates faster than the overall portfolio, you may end up selling some of the REIT index fund or vice versa.

With 7 asset classes and 8 funds across five accounts, this one won’t be too tough for Gaurav or the advisor to handle.

There you go, three case studies and while your situation won’t perfectly align with any of them, I hope you can apply the same process to your portfolio as you move to become a more competent DIY investor. If you would like even more help with drawing up your own financial plan, consider taking The White Coat Investor’s Fire Your Financial Advisor online course. It isn’t free (it isn’t even cheap at $499), but it is far less expensive than hiring a professional and even if you end up hiring a pro afterward, the course will teach you how to make sure you’re getting good advice at a fair price. At 1/3 the cost of the online courses of other physician financial bloggers, it’s looking like a better deal all the time.

What do you think? Do you agree with this process? What would you have done differently, if anything, with the portfolios in the case studies? Comment below!