How to Design an Investment Portfolio

If you hold investments, you are a portfolio manager whether you think yourself one or not. This article provides a general process to design your portfolio thoughtfully. It introduces the basic concepts of portfolio management.

There is no single best portfolio. Every investor has a unique set of objectives, risk tolerances, temperaments, interests, and aptitudes. But there are principles that can optimize a wide range of portfolios. We'll point these out along the way.

Step One: Define Parent Components

It’s useful to think of a portfolio consisting of two layers. The higher layer houses “parent” components. Parent components are thematic classifications that are personal to you based on the lens through which you view and manage your portfolio. Here are a few common patterns:

• By investment objective: Growth, Income, Store of Value, …

• By asset class: Stocks, Commodities, Real Estate, Volatility, Crypto, …

• By legal entity: Anderson Holding Corp., Digital Ventures, …

• By jurisdiction: US, UAE, Seychelles, …

• By account type: 401(k), Roth IRA, After Tax Brokerage, …

This is certainly not an exhaustive list. Parent components are as many as investors are unique. An entrepreneur may define a parent component called "Side Projects" that houses investments in his own startup experiments. A social media influencer may use a parent component called "Lifestyle" that includes houses, cars, and a and other assets used to produce content.

The classification of your parent themes do not have to be consistent. For example, it is not uncommon to see a portfolio include themes like:

Parent Theme	Classification
Growth	Investment Objective
Volatility	Asset Class
Angel Investments	Type of Investment Practice
Other	Arbitrary Catch-All

What matters is the parent themes are optimized for your circumstance.

It is typical for portfolios to end up with 3-6 parent components. For this example, let’s define the following parent components.

Parent Theme	Definition	Examples
Growth	Positions you enter primarily with the intention to profit via price appreciation.	Growth stocks, crypto, fine art, private equity
Income	Positions you hold primarily to produce income.	Stablecoin yield farms, bonds, rental properties in linear markets
Volatility	Positions you hold with the intention of hedging your other positions. Typically these positions appreciate during periods of crisis, uncertainty or "convexity".	VIXM managed options, tail risk hedge fund products

Step Two: Assign Parent Component Weights

Weights are used to define what percentage each component should make up within your portfolio, and what values to target during a rebalance.

For each of your buckets, you will assign the following weights:

1. Target weight: the percentage of your portfolio a bucket should ideally make up. This is the weight you will end up rebalancing to.

2. Max weight: the maximum percentage a bucket will grow to before you rebalance. This is the upper limit of exposure you will tolerate for that bucket.

3. Min weight: the minimum percentage a bucket will fall to before you rebalance. This is the lower limit of exposure you will tolerate for that bucket.

These weights will be used to define your rebalance rules, which we will define later.

Your weights depend on your conviction in a given component, you age, the total value of your portfolio, whether you are living off your portfolio, and many other factors. You don't have to choose perfect weights when getting started. You can always adjust these over time.

Step Three: Define Child Components

The lower level of your portfolio houses child components, which house your actual positions. Child components can be single assets, such as the $SPY, or strategies that involve multiple instruments, such as a covered call strategy on the $SPY.

Each child component includes four parts:

1. An underlying asset such as the S&P 500, Bitcoin, gold, etc.

2. An exposure strategy that defines how you will be exposed to the underlying asset.

3. For gold, this could be self-storing physical gold, or selling covered calls against a gold-backed ETF.

4. For the S&P 500, this could mean simply holding an ETF such as $SPY that tracks the S&P 500, or implementing an options strategy that buys ratio back spreads on the $SPY.

5. For Ethereum, this could be the cold storage of Ether, staking Ether in a smart contract, or using Ether as collateral to borrow more Ether on a DeFi money market.

6. An account that holds the positions. Examples include an LLC that holds Real Estate, a 401(k) that holds ETFs, or on offshore trust that holds cryptocurrency. Accounts should be used strategically to minimize your tax burden, protect your assets, and make rebalances practical.

7. A target, minimum, and maximum weight, in the same fashion as your parent company weights.

If you want to bake a quality cake, start with quality ingredients. In the same sense, your portfolio’s performance is in many ways driven by the quality of your child components.

You don't need to be an investing wizard or a crypto fanatic to create good child components. Create positions that match your level of sophistication. Keep these rules in mind:

1. Simplify as much as possible. Often it's not our strategies that constrain our investment performance, it's our ability to follow our strategies. Your ideal portfolio strategy is one you can manage long term.

2. Avoid positions that require heavy active management where possible. You want to minimize failure points. Assume you are your biggest potential failure point

3. Avoid positions with undefined risk, such as naked short selling, or writing uncovered calls. Also avoid positions whose risk you do not understand at a basic level.

4. It's generally best to avoid crypto positions that rely on un-audited technology, an anonymous team, or crypto assets with very low liquidity.

5. Seek to minimize the correlations between positions, even within the same bucket. This is important, and is a key factor in determining your overall performance. There are many techniques you can employ to decrease the correlation between your positions, which is a core topic of discussion in our community.

Step Four: Define Your Rebalance Rules

Rebalancing is your method of maintaining your desired asset allocation and risk profile - aka your target weights.

There are three common types of rebalances.

1. Time-based rebalancing: Rebalancing at predetermined intervals, such as monthly, quarterly, or annually.

2. Threshold-based rebalancing: Rebalancing when the weight of a component deviates from the target by a certain percentage or dollar amount.

3. Discretionary rebalancing: Rebalancing when your outlook or investment strategy changes in a meaningful way. For example, if your government is considering a ban on cryptocurrencies you hold, you may consider de-risking from them or reducing your target weights for crypto holdings.

You can employ just one of these approached, or multiple. For example, you may choose to follow a threshold rebalance approach, else one per year if no min or max weights were breached over the course of the year.

All rebalances use target weights to determine how much to buy and sell during a rebalance. But only threshold rebalances use min & max weights.

Time-based rebalancing, although common, comes with a few trade-offs.

• Time-based rebalancing can open you up to more risk than threshold rebalancing. For example, if you rebalance once per year, you may watch as one of your investments dwindles into irrelevance, or even bankruptcy, while you would have sold this losing position early on had you established a minimum weight.

• With time-based rebalancing, multiple periods of time can pass with little actual movement of your components. This means you can incur transaction costs and taxable events with little to no benefit to your performance, even before these costs.

• On the other hand, components can move drastically relative to one another within a period, leaving you far more overweight in certain positions than you are comfortable with, and causing you to miss key opportunities to take profits or buy sharp dips. The odds of your pre-determined cadence being the best time to lock in profits and purchase discounted assets is close to zero.

Step Five: Open Positions

Now that you've designed your target portfolio, it's time to open and fund the investment accounts needed to enter your positions, if you have not already done so.

There are many entry strategies, and no single best. Your entry strategy depends on a number of factors, including the type of positions you are opening, your time frame, and your temperament as an investor.

Some positions, such as a rental property, fine art, or a stake in a private startup, may take months to purchase. Other positions, like stocks or digital assets, can be opened in minutes, assuming the account for such positions is already funded.

But even for positions that can be opened quickly, some investors choose to enter their positions over time. Dollar cost averaging, over the course of a period, such as a month or quarter, is one example of this.

Still, other investors wait until certain price levels are reached for each position. There are techniques you can use to generate profits while you do this.

For example, if one of your positions consists of 100+ shares of a stock, and you plan to wait until the stock reaches some price below its current price before entering the position, you can consider selling a put option for every 100 shares you plan to purchase, with a strike price at your desired entry price.

Either the stock price will not reach your strike price before your put contracts expire, in which case you will retain the premium of the options contracts as profits. Or, the stock price will breach your strike price. At this point, you can close your options position and purchase the equivalent shares of stock at the same price.

Step Six: Rebalance

As your positions move in value relative to each other, the weights of your parent and child components will drift from your target weights. When a component’s weight breaches a minimum or maximum weight, you rebalance.

What counts as a breach? You can wait for the weight to touch a threshold weight intraday. But many investors simply wait until the asset closes the day beyond its threshold weight.

To rebalance, you sell the overweight component(s) by the amount they have exceeded their target weights. This locks in profits from overweight positions. You use these profits to buy underweight components by the amount they are underweight their target weights.

When a child component breaches a threshold, you rebalance only other child components of the same parent component. This is called a “component rebalance”. The result of a component rebalance is that all of the child components within the parent component are back at their target weights.

When a parent component breaches a threshold, you rebalance your entire portfolio. This is called a “portfolio rebalance.” The result of a portfolio rebalance is that all of your parent and child components are back at their target weights.

The idea is to design a portfolio of high quality components with low correlation to one another. This way, no matter what happens in the market, parts of your portfolio will likely be doing well, giving you the opportunity to lock in profits to buy underweight components at relatively cheaper prices. Rebalancing in this way can considerably boost your returns.

Step Seven: Adjust Your Strategy Over Time

Over time, your circumstances will change. You may want to take on less risk as you age, or begin optimizing for income over growth. You may improve your investment strategies and target weights as your wisdom grows. New asset classes may be born that warrant your allocation. And you may gain access to new types of investments as your capital grows, such as private equity products.

So the final step in designing your portfolio is to never stop designing.

To your sovereignty,

Sal