In this article, you will learn:
- How a good investment portfolio differs from a poor portfolio and whether you should seek the perfect one.
- The main principles for building an investment portfolio.
- How to manage your portfolio, with examples.
If you are new to investing and would like more information on the different types of assets and investment risk, we’d recommend reading these two articles before continuing with this one: ‘Your introduction to financial services and investing’ and ‘Investment Risk: What you should know‘.
What is an investment portfolio?
An investment portfolio is all the assets you have invested in. This includes shares, bonds, bank deposits, real estate etc. Forming a great portfolio means finding the best mix of assets for you.
This whole process is characterized by one word: diversification. Diversification is the distribution of money between different types of assets so that risks and potential returns match your objectives and circumstances.
Methods to build your portfolio
For most people, a typical portfolio might simply consist of stocks (shares), bonds and cash deposits. Some investors add other asset classes such as property, commodities (such as gold), or even art.
One way to build a portfolio is to invest directly in the assets. For example, you could buy shares in companies, such as Apple or Visa. If you were looking to invest in property you could simply buy one, but this is likely to be expensive!
This direct method gives you complete control, but it takes a lot of time to research where to invest. You also need sufficient money to be able to spread it around enough different assets to achieve good diversification. Investing in just a small number of assets can be risky. If one investment forms a large part of your portfolio and performs badly, this can have a very large impact on your wealth.
This is why many people look to investment funds. Each fund invests in many different assets and therefore makes it much easier for an individual investor to achieve good diversification. Different funds invest in different types of assets. Some concentrate on equities (shares), some concentrate on bonds, or property, or have a mixture of different assets. Investing in one fund gives diversification but investing in multiple funds can achieve even more diversification and still gives you control over the overall shape of your portfolio.
For more information on funds, read our article ‘Everything you need to know about investment funds’.
Creating the ‘perfect’ portfolio
Investors often spend a lot of time searching for the perfect portfolio, but does one exist?
None of us can predict the future. It’s impossible to tell which portfolio is going to perform best for us. But you don’t need the perfect portfolio, what you need is a portfolio that is a good fit for your circumstances, goals and attitude to risk. This means allocating your money across the right assets, in the right proportions.
How do you know what mix is right for you? Here are the things you need to consider:
1. Your objectives
Think about why you are investing. Some reasons might be:
- You are saving for something specific, such as a deposit for your own home, or to buy a car.
- You want to build a retirement fund.
- You want to generate regular income from the amount you have already saved.
- You simply want to protect the value of your money against inflation.
The more specific your goal, the better: work out how much money you need and why. This helps you to understand the type of investment to go for and how much risk you might be prepared to take to achieve your goals.
2. Your time horizon
This is critical to your portfolio. When do you expect to need access to the money you’re investing? Let’s take the example of saving for a car. When do you want to buy it? If it’s five years’ time, then your investment time horizon is 5 years.
This is important because the more time you have, the more risk you can potentially take. If the stock market has a big fall, you will want to ensure there is time for it to recover. If you need access to the money within the next 5 years, a lower risk portfolio may be appropriate to minimise short term losses. If you are looking 20 years ahead, you may be more comfortable riding out the ups and downs of the stock market.
Over time, your investment horizon will become shorter because you’ll gradually get closer to the point you will need the money. It’s therefore a good idea to gradually reduce the proportion of volatile assets such as shares and move your money into assets with a lower risk of loss.
3. Capacity for loss
If your portfolio lost money in the short term, how would it impact you financially? If you couldn’t manage without the money you’re investing and it would impact your quality of life now, then it’s probably not right to be risking it on the stock market. This is part of the reason why some of your money should always be held in cash deposits.
4. Risk appetite
It’s not just about coping financially with a fall in your portfolio’s value; how would you actually feel? How prepared are you to take risks for a potentially higher return? In a bear market, where market confidence is low and share prices are generally falling, a portfolio can lose maybe 20-25% of its value. During the financial crisis of 2008-9 the main US stock market, the Dow, dropped more than 50% from its peak to its lowest point. It then took four years to recover. If your portfolio suffered a significant fall, would you lose sleep, or would you be happy to stay calm and ride it out?
The more tolerant you are of price fluctuations and the risk of losing money, the higher the proportion of shares in your investment portfolio can be.
Finding your risk level
Investment managers, such as Tukki, often provide questionnaires to help customers to assess their attitude to risk. These typically look at how much loss you would be prepared to tolerate for the chance of a return on your money. This can help identify a mix of assets with a risk profile that matches your attitude.
For example:
If you are not prepared to see the value of your portfolio drop by more than 5-10% in year, you are a fairly conservative investor. This means that higher risk assets such as shares should form a relatively small part of your portfolio.
If a temporary fall in the portfolio value of 15-20% is acceptable for you, you are likely to be a moderate risk investor. This means you might be suited to what is typically known as a ‘balanced’ portfolio, where shares may make up around half of your portfolio, depending on your time horizon.
If you are prepared to take a high risk for the potential of higher returns and could accept a severe drop in the value of your portfolio during a crisis, perhaps 40-50%, you are a more adventurous investor. This usually means you can expose most of your portfolio to equities. The key is not to overestimate your resilience: thinking about the crisis and experiencing it is not the same thing.
It’s more important to avoid getting your asset mix wrong than getting it perfect. Take too much risk and you might get a nasty surprise if the market falls. Take too little risk and you might not get the opportunity to meet your objectives.
Asset Allocation Example
Here’s what the mix of assets might look like for a person who is reasonably conservative or perhaps has a medium-term time horizon (please note this is not advice, simply an example):
| Equities | 40% |
| Fixed interest (bonds): | 40% |
| Cash: | 20% |
Each of the assets performs a different function in the portfolio. The equities provide the potential for growth, but at the expense of higher volatility in returns. The bonds provide a more stable return, reducing the volatility of the portfolio but this also reduces the potential for growth. The cash again reduces volatility and ensures there is some money readily available if needed.
More diversification!
Diversification is not just spreading money across different types of assets. It is also about choosing a spread of investments within each asset class.
For example, shares of developed markets tend to perform very differently to those in emerging markets, and there can be significant differences in each country. In the 1980s, Japanese shares appreciated rapidly, so it was profitable to invest in them. By the early 1990s, prices had fallen dramatically and did not recover well. Those who invested only in Japanese stocks lost a lot of money.
The more prudent investors invested in stocks of countries across the world and in different types of market. It is the same with industries: if you only put all your money into technology stocks, this will not achieve good diversification.
It’s also possible to diversify by company size. Large established companies tend to offer more stable returns but lower growth. Smaller companies can offer large potential for growth in their share price, but at a much higher risk of failure.
Sustainability may also be something you want to consider. It’s possible to achieve good diversification while avoiding industries and companies you don’t want to support with your investment.
Portfolio management
Unfortunately, it’s usually not enough to set up a portfolio and then ignore it. An investment portfolio requires attention.
Over the long term, stocks are usually expected to appreciate at a faster rate than bonds and cash. This means that a portfolio will eventually have more of its value in shares. At the same time, your objectives may have changed, and your time horizon has probably reduced. This means you may now have too much of your portfolio exposed to riskier assets.
Therefore, it’s important to keep an eye on your portfolio to ensure the asset mix, and therefore the risk level, doesn’t move too far from your intention. If it does, you may need to shift some of your money between investments. This is known as ‘rebalancing’.
Let’s look at the example portfolio above with a 40:40:20 split between stocks, bonds and cash. If we assume the investor made a $50,000 initial investment, let see what happened in this hypothetical investment over a period of time:
| Target asset mix | Investment in each asset | Growth achieved | New value | New asset mix | |
|---|---|---|---|---|---|
| Equities | 40% | 20,000 LKR | 20% | 24,000 LKR | 44% |
| Bonds | 40% | 20,000 LKR | -1% | 19,800 LKR | 37% |
| Cash | 20% | 10,000 LKR | 2% | 10,200 LKR | 19% |
| Total | 100% | 50,000 LKR | 8% | 54,000 LKR | 100% |
We can see that the equities have grown strongly, cash by a smaller amount, and the bonds have lost a little value. This has resulted in more of the investor’s money being exposed to equities than they intended and less to bonds and cash. Their portfolio is therefore riskier than they planned. To rebalance their portfolio, they could:
- Invest more money and buy more of those assets that have fallen in price; or
- Sell some equities and use the proceeds to buy bonds or to hold in cash.
Funds – the ready-made portfolios
As we discuss above, choosing the right place to grow your money can be hard, and building a portfolio by investing in individual stocks tests even the most experienced investor. It takes a lot of time, knowledge and effort to research and monitor individual companies in order to create and stay on top of your portfolio.
Investment funds do a lot of this work for you by investing in a range of companies that match the fund’s objective and risk profile. Although they come in different forms, all funds have one important thing in common: they pool the money from many investors to buy a range of assets. Rather than owning these assets directly, you own units or shares in the fund. As the total value of the assets held by the fund rises and falls, so does the value of your holding in the fund. For more information on funds have a look at our article ‘Everything you need to know about investment funds’.
Here is a summary of the most important points from this article:
- You need to build the right investment portfolio, but it doesn’t need to be perfect. It is essential to consider your goals, investment horizon and attitude to risk. This will help you identify the right mix of assets for you.
- The longer ‘time horizon’ you have, the more risk you can typically take with your portfolio. This usually means having a higher proportion of your money in shares.
- It is riskier to invest in one type of asset, one company, industry or country. Diversification is the key to managing risk – dividing your portfolio between different types of assets and between industry sectors and countries.
- Over time, the shares of assets in a portfolio may change because some assets rise or fall in value more than others. To keep the portfolio’s risk under control, you must occasionally rebalance. This means restoring the desired proportions of assets, and as you progress towards your objective, reassess whether your asset mix is right. This usually means reducing risk as you progress towards your target date.
- Directly investing in assets can be tricky. Investing in funds makes diversification and rebalancing much easier for individual investors.
Interested in Investing?
Investing can be daunting but also rewarding if you do your research before leaping in.
Tukki can help you get started with investing. Have a look at the other articles in our Investment Academy.
