What is an investment portfolio?
An investment portfolio is simply a group of assets. Technically speaking, anything you buy and plan to sell later is part of your portfolio. This includes
- Hedge Funds,
- Real Estate
But generally, and for the purposes of this article, an investment portfolio refers to the more liquid cash and securities you've invested in to earn a return. This includes:
- Mutual funds
- Exchange-traded funds (ETFs)
ETFs make up the majority of most people's investment portfolios. Your portfolio can be run by a manager or automated with a robo-advisor. Or handle the investments yourself.
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Understanding risk and return
Various assets in your investment portfolio react differently to changes in the financial markets. At any one time, some may rise and some may fall. It's important to understand that there is no such thing as a risk-free investment.
But balance risk and return by diversifying the assets in your investment portfolio. The idea behind diversification is to not have all your eggs in one basket. You should try to build up, manage and maintain your investments prudently. Balance the risk and reward appropriate to your goals, temperament, and circumstances.
No one can predict how stocks and bonds will move over a month, a quarter or even a year. But the market tends to look forward. And it is likely to improve before the economy or sentiment does. We're seeing this in the U.S. now, with falling GDP and record unemployment. Yet investing in stocks is at or near record highs.
We can't predict or time the markets. But we can see how they have behaved in the past and use that information to guide us. Disease, war, famine — all of those have happened in the past, yet the market's long-term trend is up. When planning an investment portfolio, we recommend planning on a minimum three-to-five-year timeframe.
Dow Jones 100-year historical return, showing an upward trend. The grey represents recessions.
How to build an investment portfolio
When you're building an investment portfolio, there are two things to consider:
- Timeframe — When do you need the money you're investing?
- Your Risk Tolerance — How much fluctuation in the value of your investment portfolio can you withstand?
Once you have those two things figured out, start to think about which types of assets you want to invest in.
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Timeframe effect on portfolio allocations
If you're age 60 and planning on retiring soon, you might choose a five-year timeframe. If you're 20 and want to invest savings for purchasing a home, you might wish to take your money out in 10 years.
You should invest only money that you do not need for your day-to-day living expenses. You do not want to be forced to liquidate your investment portfolio before your timeframe ends. If you sell the investments in your portfolio prior to your timeframe, you may be forced to accept lower prices than you would have, had you waited until the timeframe ended.
The timeframe you have also helps you decide which types of investments to consider. For example, if you're closer to retirement, you should have a more conservative or risk-adverse portfolio. But if you're younger and won't need the money for a while, you can take on riskier investments.
Of course how much risk you decide to take depends on your personal risk tolerance.
Risk tolerance effect on portfolio Allocations
If you invested $1,000 today and a market disruption occurred next week (as it did in March 2020 when news of the COVID-19 virus spread) and your investment portfolio was suddenly worth $700, what would your reaction be? Would you feel that investing is not for you and want to sell your investments? Or would you say to yourself, “Markets fluctuate and I am investing for the long term so I will ride this out,” possibly investing more?
- If you responded by wanting to sell, you may be said to have a low tolerance for risk (volatility).
- If you responded by wanting to buy more and were not derailed by the setback, you may be said to have a higher tolerance for risk.
Understanding your temperament is critical for investment decision-making.
For investment portfolios, the risk is measured in terms of fluctuation or volatility. Risky security is one that fluctuates by 20% or more, moving from $10 to $12 one day and then to $9.60 a week later.
Risk and reward often go hand in hand. High-grade bonds on the whole fluctuate less than stocks. In fact, bonds are said to be more stable than stocks, though of course there are outlying exceptions. High-quality bonds also offer lower returns than stocks. But bond returns are more predictable than stock returns.
What is peculiar about the investment environment right now is that interest rates — that is, bond rates — are extremely low. And sometimes it is possible to find stable stocks with a higher dividend yield, such as Verizon (4.2% as of January 2021), than the 10-year U.S. Treasury bond (1.2%).
Determine your investment portfolio's asset allocation
Once you have determined your timeframe and level of risk, decide on your investment portfolio's asset allocation. Asset allocation is the mix of investments you have in your portfolio. This includes stocks, bonds, precious metals, real estate, cryptocurrencies, and more. But for this article, we will focus on stocks (with their higher expected rates of return) and bonds (with their more predictable returns).
A great way to choose your investment portfolio's allocation is to mimic the allocation provided by professional investors such as Vanguard, Fidelity, and BlackRock. Each of these companies offers retirement portfolios geared toward a specific retirement year.
For example, Vanguard's Retirement Target 2025 portfolio is about 61% stocks and 39% bonds. So if your timeframe is five years, a mix of 60% stocks and 40% bonds is a well-founded suggestion.
For the 10-year timeframe, Vanguard's 2030 portfolio allocation is roughly 68% stocks and 32% bonds, which may be appropriate for the investor saving to buy a house around the year 2030.
For more hands-on advice, consider working with a financial advisor. You can use the services of Paladin Registry to find financial advisors who are also fiduciaries, meaning they are legally obligated to put your interests first.
More: Why the traditional 60/40 portfolio is in danger and what you can do about it
Types of investment portfolios
By altering the allocation and composition of your assets, you can put together an investment portfolio that suits your temperament and outlook. But there is no need to reinvent the wheel. You can often find reputable mutual fund companies that offer these types of investments. And you can structure your own portfolio by using the mutual fund company's holdings as a rough guide for selecting your own investments.
Suppose you have a high tolerance for fluctuations in securities prices and a lengthy timeframe. You could structure an aggressive portfolio with a very high allocation of stocks, say 90%. Besides stocks, you can decide to add in some low-rated (or “high yield”) bonds that respond as stocks do to changes in the marketplace. Aggressive portfolios tend to include stocks of companies that are not well-known and are in the early growth stage. Click to read all about
You could also structure a hybrid portfolio, which has more diversity in different asset classes. For example, you might have a portfolio consisting of stocks, bonds, and commodities. And perhaps you add some real estate investment trusts (REITs) to boost yields on the bond side of your investments. You can even add in some art (which you can do by investing in blue-chip art via Masterworks).
A hybrid portfolio usually has a fixed proportion of stocks, bonds, and alternative investments. For example, a portfolio of 60% stocks and 40% bonds is considered a hybrid portfolio.
If you want to take less investment risk, construct a defensive portfolio consisting of the stocks and bonds of companies that have consistent earnings in both up and down (bull and bear) markets. This type of portfolio focuses on consumer stables. If you're of the opinion that a recessionary environment may soon set in, you can invest in stocks and bonds in sectors that are less sensitive to the economic cycle (e.g., pharmaceuticals and food suppliers). Basically, stocks in a defensive portfolio usually perform well even when the economy is down and help you reduce your exposure to volatility in the market.
Another option is an income portfolio. This includes investments that give out regular payments. This type of portfolio includes bonds that pay interest and stocks in companies that consistently give out high dividend yields, such as the dividend aristocrats. REITs are another type of income-producing investment. However, these types of portfolios can be more susceptible to changes in the economy.
And finally, if you want to take a lot of risk, invest in a speculative portfolio. This includes investments in initial public offerings (IPOs) and stocks of companies that are rumored to soon make a big breakthrough or merger. This is probably the riskiest of the portfolio options available and not for the faint of heart. If you're not experienced with investing, this is probably not the best portfolio to start out with.
Managing your investment portfolio
Each year, as markets change and securities in your portfolio appreciate and depreciate, you should compare your investment portfolio again with the composition of mutual funds, ETFs or professional investors. You may need to buy or sell securities in order to maintain the recommended allocations in your investment portfolio.
If your stocks have appreciated by a large amount, you might consider adding to your bond holdings to keep the allocation percentages in line with the pros. This is called rebalancing and simply means tweaking your portfolio to account for changes that have occurred.
Tools like Stock Rover can connect to your brokerage accounts and show you what manual rebalancing adjustments need to be made. Or if you invest in with a robo advisor like Betterment or Wealthfront, this will automatically be done for you. Also, some wealth managers include portfolio rebalancing in their services.
Putting together your investment portfolio begins with understanding your timeframe and your risk tolerance. Then think carefully about how you want to allocate your money into different assets such as stocks and bonds.
You can model your investment portfolio allocation on what the pros are doing by examining their target retirement portfolios. Or use a robo advisor.
Having a clear understanding of your objectives, your risk tolerance, and the amount of time your money can be invested are the most important steps to creating an investment portfolio. In fact, these steps distinguish investment from speculation (or gambling).
No matter your age or experience, think through the recommended steps, make a plan, and research. While we can't predict markets accurately, we can take steps to increase the probability of success. You will be in a far stronger position to weather the ups and downs of the market and may even enjoy the ride.
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