How to Build an Investment Portfolio
An investment portfolio is a collection of financial products carefully chosen from different asset classes in proportions that suit the investor’s risk profile. This might include investments such as stocks, bonds, real estate, commodities, even hedge funds, and the new age asset class- cryptocurrency. By building an investment portfolio, investors aim to earn a sizable return on their capital by leveraging the risk-return potential of investments. Additionally, by diversifying their assets across different baskets, according to their financial goals and risk appetite, they are also minimizing the risks arising from the investments. Knowing what investments to consider while diversifying your portfolio can be challenging which is why it is highly recommended to use the services of a financial advisor for further assistance.
In this article, we will discuss in-depth the meaning of an investment portfolio, how to build a portfolio, various kinds of portfolios, and how one can position their investment portfolio to capture maximum gains from the market.
What is an investment portfolio?
An investment portfolio is defined as an amalgamation of asset classes that can include investment options such as equity, government bonds, mutual funds, real estate, and commodities, among others. An investment portfolio is created with the expectation of generating good returns as an alternate source of income. These returns are market-linked, depending on the amount of exposure, and more often are directly proportional to the risks undertaken. The lower the risk you take, the lower your returns are; the higher the risk you take, the higher is the potential for rewards.
When creating a portfolio, one of the most important things to consider is the risk profile one has and match it to the risk involved in investing in the product. A risk profile is based on one’s risk appetite and risk tolerance. Risk appetite is the amount of risk you are willing to take with the hope that higher results will stem from it. Risk tolerance refers to the propensity to bear losses in investments.
Risk profile depends on factors such as age and income. For instance, someone in their 20s can take a higher degree of risk for a potential reward as opposed to someone in their 50s who is nearing their retirement.
Read our article on Understanding Your Investment Risk Profile to understand the concept and its importance in successful portfolio creation.
How to build an investment portfolio
We have broken down the process of how one can build their investment portfolio into a palatable 3-step guide.
Step 1: Understand your current financial situation and assess future needs
It is vital to develop a deeper understanding of your financial situation and future goals when developing a portfolio. As mentioned earlier, someone in their early 20s with no dependents would have a very different strategy in comparison to someone in their 50s with dependents. Jot down your current sources of income, your expenditure, and future expectations depending on the lifestyle you have and wish to have. It helps to be realistic in setting SMART financial goals.
[See: How
to Set Short, Medium, and Long-Term Financial Goals]
Plan out your budget and personal finances to allow for savings from your
current income so that you may make suitable investments to generate passive
income from them.
Next, figure out your investment strategy. It is important to recognize whether someone is a conservative investor (someone who prefers value investing or safe and steady income) or an aggressive investor (prefers quick capital appreciation over safety or regularity of returns).
Completion of this step will determine which asset classes to opt for while allocating your funds.
Step 2: Allocate your assets
The next step is to allocate your funds into various asset classes such as stocks, bonds, and cash and equivalents. Different asset classes offer different return and risk profiles. For instance: someone with a higher risk appetite will opt for asset classes such as stocks or cryptocurrency, which are volatile but also offer potential for higher returns; whereas someone with a lower risk appetite will opt for asset classes such as fixed income where the risk is lower.
Asset allocation is extremely useful because it helps an investor diversify their funds and subsequently reduce the inherent risk involved. The market movement that might lead one asset class to produce exponential returns might also cause the performance of another asset class to be sub-par. With proper asset allocation, an investor can offset market movements against each other, producing a portfolio that is less prone to market volatility and movements.
Consider the following assets when creating your investment portfolio:
Stocks:
Consider factors such as market capitalization, sector, management, and others while selecting the right stock for your portfolio. It is important to fundamentally understand the operations of a company in order to determine the growth opportunities and risks involved in the process of investing in equity as an asset class. Selecting individual stocks is not an easy task and requires one to stay updated with the latest happenings with the company and the prevailing market sentiment. Equity is known to be the asset class with the highest risk factor but is also the established kingpin for wealth generation over the long term. Staying invested without being swayed by the market has historically made many millionaires.
Mutual funds:
Mutual funds provide diversification of investment within a single product. They allow individuals to hold an amalgamation of stocks that are professionally picked, and the fund is managed by qualified fund managers. Index funds are a type of mutual fund that mirrors the market index and are hence passively managed. These are good options to consider, especially for an investor who is starting out in the equity market.
Bonds:
When selecting bonds, factors such as maturity
duration, the credit rating of the bond, interest rate, etc., must be
considered. This is an ideal asset class for investors who seek to grow wealth
over the long term alongside the protection of capital and not take on a lot of
risks. Bonds are less risky when compared to equity but also offer lower
returns.
Cryptocurrency:
Cryptocurrency is a new entrant to the asset class status. The world is for now divided on the inclusion of digital coins in investment portfolios. However, it is imperative to bring up that there is increasing acceptance of cryptocurrency and crypto markets across the globe, and many speculate and call it the ‘future of currency.’
[See: Should you Include Bitcoin in your Retirement Portfolio?]
HNWIs and UHNWIs may also explore asset classes such as private equity and hedge funds that are high-risk investments and involve large upfront payments.
Step 3: Assign weights to different asset classes
It is important to take note of factors such as market volatility, investment horizon, and risk profile while allocating weights to different asset classes in your portfolio. ‘Weights’ refers to the percentage of your investment portfolio that you will assign to each of your chosen asset classes. As and when changes are observed in these variables or even the market reaction, it is important to mold and rebalance the portfolio in accordance.
For example: if one has started a family and hence the risk appetite has dropped, including more debt and less equity in the portfolio might be the right adjustment to make. Should you feel like you are at a phase in your life where you are comfortable taking on a higher risk, then giving higher weightage to asset classes such as equity and cryptocurrency might be a necessary move.
It is important to keep rebalancing the weights assigned to different asset classes as and when the market or present conditions change.
Types of the investment portfolios
Even though an investment portfolio is unique to every individual, given below is the broad characterization of various kinds of portfolios.
– The aggressive portfolio:
An aggressive portfolio seeks exponential returns and takes on high risks to achieve it. This portfolio generally has higher exposure to equities than other asset classes. This is because equities have the highest risk-return ratio and the potential for quick capital appreciation but at higher levels of risk exposure. The stocks within the equity portion are also extremely sensitive to market volatility and generally experience major fluctuations. The aim is to capture as many returns as possible from the market exposure, and the investor is most often willing to take on more risk towards achieving that. It is vital to manage the risk wisely and only bite as much as one can chew.
– The defensive portfolio:
A defensive investment portfolio is one for conservative investors. The exposure to risky investments is minimal here, and capital protection takes the front seat. Such a portfolio may not return heavily but will work slowly to build wealth over time. Asset allocation to debt is more than the allocation to equity in defensive portfolios. The stocks in this portfolio are minimal and are not very sensitive to the market movement either. This portfolio usually comprises investments such as bonds that give consistent returns regardless of the conditions in the economy. Risks generally arise from interest rate changes.
– The income portfolio:
This kind of portfolio primarily focuses on creating additional sources of income for the investor, mainly in the form of dividends. There might exist an overlap in the companies that would be included in the defensive portfolio and income portfolio. The difference, however, is that companies in the income portfolio are primarily selected for their high dividend yields. This portfolio helps generate a positive cash flow for the investor and would also include investments such as Dividend Funds and Real estate investment trusts (REITs) too.
– The speculative portfolio:
This is the riskiest portfolio there is. It is aimed at medium to long-term investors who seek above-average capital growth from their investment portfolio of mainly global equity investments. It is also called the Alpha portfolio because of the high exposure to risk. A speculative portfolio may be overweight on equities and hedge funds and, in many cases, futures and derivatives market trades and cryptocurrency too. It is imperative that the investor is aware of the risks involved and makes the asset mix carefully. The investment horizon is often short, and the investor may have a ‘pump and dump’ approach.
– The hybrid portfolio:
This type of portfolio includes a mix of various other asset classes such as equity, bonds, real estate, commodities, and others. A hybrid portfolio comprises investments in asset classes in predetermined ratios and offers a diversification of portfolios apart from the stability of returns. There is a higher level of risk management by spreading funds across asset classes with less correlation, so there is always a safety net available. A hybrid portfolio is also called an all-weather portfolio.
Investment portfolio types based on age
Case 1: Someone in their 20s
Rebecca, 27, just graduated from business school. She currently has no dependents and is earning six figures every year. She is also paying off her education loan and has just started building her savings in her 401(k).
For someone like Rebecca, a portfolio consisting of a majority investment in stocks makes greater sense as she has many years left before retirement. She can afford to take a higher risk for more rewards. Also, to provide some stability to the portfolio, we may include ~10-25% of bonds in her investment portfolio.
This would constitute an Aggressive Investment Portfolio, and Rebecca can be called an aggressive investor. However, should situations change, her portfolio must change accordingly to protect her capital and build wealth over time.
Case 2: Middle-aged:
Dan, 46, is married and has two kids, one of whom is getting ready to go to college next year. He is the sole earning member of the family and currently earns a five-digit monthly salary.
For someone like Dan, this is the right time to do some portfolio building as he is probably nearing his peak earning potential. Even if Dan is saving up for the college funds for his children or paying his house mortgage, building up his retirement fund should remain a priority. Exposure to stocks is advisable to allow time for the funds to grow and give returns that beat the inflation rate. It is also advised to continue to max out contributions to 401(k) and IRA to have a guaranteed return in the future.
A combination of 60% allocation to equity and 40% allocation to debt investments may work to provide the balance between wealth generation and capital protection. All other conditions void, Dan could be categorized as an investor with a moderate approach and may build a Hybrid portfolio to suit his requirements.
Case 3: Nearing retirement:
Stephen, 59, is very close to his retirement age. His children are now independent, which means he only needs to focus on his retirement funds.
For someone like Stephen, it may be advisable to stay away from risky investments and take a more conservative approach to safeguard his money to live out his retirement in peace. It may make sense for him to convert some of his investments from stocks and other related securities into bonds and pension funds to negate the chances of losses and guarantee some returns.
For people approaching their retirement, the IRS allows them to put more funds in their retirement accounts. Workers who are 50 and older can contribute an additional $6,500 per year to their 401(k). This is referred to as “catch-up contribution.” (Note that the catch-up limit is amended by the IRS periodically).
An ideal portfolio for Stephen would be 70-80% debt, and the remainder spread across equity and real estate, etc. Stephen’s profile is that of a risk-averse investor, and his approach is conservative. The investment portfolio suitable to him is either an Income Portfolio or a defensive portfolio.
Please note that these are just cases for reference and not investment advice. As mentioned before, no two investor cases are similar as the financial situation, goals, time horizon, risk profile, as well as an investment strategy, vary from person to person. It is highly recommended to consult a financial advisor before you get to building your investment portfolio.
How to improve your investment portfolio
Here is how one can improve the performance of their investment portfolio and get higher yields:
1. Diversify your investments
When allocating funds in your portfolio it is extremely important to remember to diversify into different asset classes and also within asset classes. For instance: when investing in stocks, one should buy shares across company sizes and industries to diversify the portfolio. This not only helps buffer against losses but also helps to capture growth from industries and sectors that are witnessing an uptick.
2. Reinvest your dividends
Reinvesting your dividend income can give an extra boost to your portfolio returns, especially if you are in the early years of investing. This feeds into the concept of the compounding power of money – also the reason why experts often ask to start investing as early as possible. This extra money from dividends reinvestment will go towards increasing the investment base on which interest will be earned, thereby aiding the corpus growth significantly.
3. Lower your portfolio churn rate:
Frequently selling assets from an investment portfolio can be a costly affair and may reduce long-term portfolio returns. Hence, it is advised that a buy-and-hold strategy is followed, and investments are held to a long term.
4. Consult a financial advisor
There are various pointers to consider while creating an investment portfolio as well as many variables. It may be prudent to consult a qualified financial advisor or an investment advisor when you are trying to build an investment portfolio. They will be able to help you streamline your investments according to your risk profile to benefit from the growth opportunities in the market.
To sum it up
An investment portfolio allows the investor to reduce and diversify their risk. It also allows the investor to position their funds in a manner that they earn sizable returns, which help achieve both short-term and long-term financial goals.
Therefore, it is vital to determine both short and long-term financial goals and understand your risk profile before building an investment portfolio. When creating an investment portfolio, one must not only diversify their portfolio by including different asset classes but also must spread the risk within each asset class. Using asset allocation strategies may come in handy when devising investment portfolios.
To get in touch with a fiduciary advisor who can help you devise smart financial strategies to create a successful investment portfolio, use Paladin Registry’s Free Search Tool. Based on your requirements, our platform scans through our registered and qualified advisors to match you with a financial advisor suited to your needs and goals.
To learn more about the author William Hayslett view his short bio.
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