A “portfolio” denotes a curated selection of items—you might commonly hear of an artwork portfolio or a portfolio of a student’s work. And in the case of the financial world, an investment portfolio is a curated selection of (you guessed it) types of investments. If you’re new to investing—or just think you might need some guidance—you’re probably wondering how you would assemble an investment portfolio that’s right for you. Below, we break it down for you.
What is an Investment Portfolio?
An investment portfolio contains a selection of investments. Common choices include shares, bonds, mutual funds and currencies, but an investment portfolio might also include more esoteric assets, like art or real estate.
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One of the newer classes of investments gaining in popularity in investment portfolios are exchange-traded funds (ETFs). An ETF is basically a “basket” of several different components that trades on the stock exchange like a single entity. That means you can buy and sell shares of an ETF just like you would a share, but you’re getting the benefit of several different types of investments, rather than just one, in that single product.
What should you consider when building your Investment Portfolio
Just as an art portfolio would include specially selected works that reflect your taste or interests, your investment portfolio should similarly be chosen to include a mix of different types of investments that meet your unique needs.
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There are several elements you should take into account when composing your own investment portfolio, as each one can influence your potential returns. The top three to consider are:
1. Risk tolerance
There are two ends to the risk spectrum—on one side are conservative investments and on the other are aggressive investments—with all the variances in between. While any investment has a certain degree of risk, you stand to lose less if you stick with conservative investments—but you’ll also gain less if they rise.
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That’s because the higher the risk of the investment, the potentially higher it goes, but the lower it sinks in market fluctuations. Risk tolerances will vary depending on your life situation (see an explanation of “time horizon” below) but also your own personal preference. If you are more risk-averse and know you are too anxious to withstand the normal zigzags of the stock market, then you might want to choose potentially stable investments, such as certificates of deposits (CDs) or bonds. But you must be aware that you could be missing out on growth opportunities, and thus forgoing potential returns, which can yield a less robust nest egg over time.
2. Time Horizon
This refers to how long you have until you need to use the money you have in your investment portfolio. If you are just starting out and are saving primarily for retirement, then time is on your side: Even if your investments dip in the short-term, history has shown that you are likely to recoup much or all of that investment as the market recovers.
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But, if you need the money soon—say you are intending to parlay your investment into the down payment on a house or you’re planning to use it to fund college for your daughter who’s just finishing middle school—then you would want that part of your investment portfolio to be a bit more protected from market fluctuations. That’s because if a recession hit and the market plummeted, you might not have enough time for your money to grow back to where it was before you needed to take it out.
3. Diversification
If you only own one type of investment and it skyrockets, well, that’s great news. But you always have to consider the potential downside: If that one investment sinks, then so does your entire investment portfolio along with it. It’s smart to have holdings in different types of investments, or asset classes, to help smooth out bumps in each one. So, if shares fall, then bonds will still hold their value. One example of diversification are the asset classes in different ETF portfolios, which include:
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Real estate
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Large companies
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Small companies
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Government bonds
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Corporate bonds
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Emerging markets
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Another way to manage diversification is by choosing to create variety within a specific asset class. For instance, you may have investments that are all shares, yet they are in a wide range of companies and industries so that you are not overly reliant on, say, tech or manufacturing, in case an entire sector falls out of favor simultaneously. However, of course, the flip side is that if tech hits a boom while manufacturing slides, a portfolio with shares in each won’t be able to fully enjoy that success. Ah, the many decisions we have to make when building an investment portfolio.
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While you don’t have to have every asset class included, it’s smart to ensure you have a good mix. In fact, you may have heard of “modern portfolio theory.” This reflects the belief that a portfolio’s ultimate success hinges more on its overall risk and return profile than the risk-return profile of any of its individual investments. An investor can use that theory to build a diversified portfolio of multiple assets or investments that is designed to limit risk and maximize returns when considering the whole of the investment portfolio.
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That desire for diversification is another reason that ETFs and mutual funds are so popular, since they are inherently diverse and contain dozens or hundreds of different types of shares or bonds.
How do I create and maintain an ideal investment portfolio?
Well, that’s the Holy Grail, indeed, and what every individual and professional money manager strives for. An ideal investment portfolio would be described as one that offers the maximum potential for return, while minimizing the risk of catastrophic losses. Those in the investing business call this the “efficient frontier.” You are most apt to achieve this by making sure you are wisely diversified.
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The other thing to keep in mind is that your various investments are constantly going up and down with market shifts, which over time can push your investment portfolio out of whack. Case in point: If you decided to build a portfolio that was a 70/30 split of shares (more aggressive) and bonds (more conservative), and the stock market shoots up, those shares might grow in value so much that your portfolio ends up being 90/10 in favor of shares.
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Now while there’s nothing inherently wrong with that ratio, you have to consider your own personal circumstances, time horizon and goals. If you choose to return to the split you had initially chosen, you’ll need to ”rebalance” your portfolio; That means you’ll need to sell shares and buy bonds to get back to that 70/30 ratio.
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Of course, that can be challenging—after all, who wants to sell those winners? And keep in mind that as your circumstances change, so should your investment portfolio. For example, as you near retirement, you’ll want to make changes that will aim to keep your investments on solid ground despite market conditions.
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While investing is never fool-proof, your best option is to build an investment portfolio that takes into account your income, age, time horizon, risk tolerance and goals—all the individual pieces that make up the puzzle of your ideal investment portfolio.
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This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
