‘Investment portfolio’ is one of the terms you will come across as you venture into the investing industry. While building a good investment portfolio might seem intimidating at the start, the good news is that you do not necessarily need to be wealthy or even have many years of experience as an investor to succeed.
In this article, we will go through the basics of building a solid investment portfolio.
What Is an Investment Portfolio?
An investment portfolio is a collection of various financial investments including stocks, bonds, cash, commodities, and cash equivalents. While stocks and bonds are typically considered the building blocks of an investment portfolio, it is possible to create one using different asset types.
Investors seek to build a well-managed and diversified portfolio to distribute their risks, manage risks, and increase returns from their investments. For example, you could own a stock portfolio and invest 20 percent of your portfolio in different stock categories and you would have a diversified portfolio.
While there are certain rules to portfolio management, different investors approach their portfolios in different ways depending on factors such as their age, tolerance for risk, and investment goals.
Such approaches lead to different types of portfolios.
Types of Portfolios
Different types of investors approach portfolio diversification in different ways, resulting in a variety of investment portfolios. The approach you pick will depend on your personality, investment style, and risk appetite. Here are the common types of portfolios:
An aggressive portfolio attempts to maximize returns by taking a higher degree of risk, typically emphasizing capital appreciation rather than income or safety of principal. Aggressive investors typically go for high-risk, high-reward asset classes such as equities and commodities.
An aggressive portfolio requires active management as it comes with higher volatility and may need frequent adjustments. Most aggressive investors go for fast growth, for instance, growth stocks.
Aggressive investors must have sharp risk management techniques to minimize their losses and increase their returns.
In aggressive portfolio management, the investor relies on strategies such as asset allocation and asset selection. In a defensive portfolio, the investor looks for securities with specific characteristics such as reduced volatility.
To build a defensive portfolio, you need to select stocks that historically have a lower level of volatility in down markets. Defensive stocks are a good candidate for this portfolio, as they tend to do well in good and bad economic times.
The income portfolio focuses on investing in assets that generate income for the investor through dividends or other distributions. The income portfolio includes some defensive stocks (as they tend to pay dividends) and other high-yield stocks.
Examples of investments that work well in an income portfolio include real estate investment trusts and master limited partnerships. These investments return a majority of their profits to shareholders.
Note, however, income-generating investments such as REITs move with the economic climate, often taking a beating during economic downturns.
A speculative portfolio often involves taking more risk. In speculative investment, the investor seeks to profit from price fluctuations as the market changes. Angel investors and venture capitalists are an example of speculative investors as they typically invest in high-risk investments with an incredible potential upside. Although speculative investments are high-risk, they can be very rewarding if the investor’s speculation works to their advantage. That said, experts recommend that you invest a maximum of 10% of your portfolio in speculative assets.
A hybrid portfolio is highly flexible. It includes a mix of different stocks, bonds, and other securities in different proportions.
Building a Solid Investment Portfolio
Now that you know the common types of investment portfolios, it is time to build one for yourself. Building your own investment process looks different for every investor, but here are the general rules and steps to lead you to a good portfolio.
Know Your Risk Tolerance
Risk tolerance refers to the level of uncertainty an investor can handle in their financial planning and investment. An investor’s risk tolerance depends on a variety of factors including age, personality, and your net worth, and disposable income.
Understanding your risk tolerance is critical in avoiding panic-driven mistakes such as selling too soon or emotional trading. Knowing your risk tolerance also helps you choose the right investments that match your personality and risk appetite. That said, here are some of the factors that affect an investor’s risk tolerance:
- The ability to take risks. Your current income, liabilities, commitments, debt, and age may affect your ability to take risks. In general, younger individuals with few liabilities can take more risks.
- The need to take risks. Your financial goals and the returns you expect from your investments will influence your need to take risks. For instance, if you are working towards a down payment on a house in the next five years you may need to take higher risks than say, saving for retirement.
- Your willingness to take risks, which is highly dependent on your personality
- Your time horizon; shorter investment horizons limit your ability to take higher risks.
After considering these factors, you may fit into one of three risk profiles:
- Diversify Your Investments
Whether you are an aggressive or conservative investor, diversification is key to a solid investment portfolio. Diversification safeguards your investment from undesirable market conditions while providing optimal returns.
The goal of diversification is to distribute your risk and minimize it as much as possible so that no single investment has a large effect on your overall portfolio or returns.
Choose an Investment Account
You will need an investment account to build your investment portfolio and you should choose one that helps you towards your goals. For example, if you are investing for retirement, a retirement account such as an IRA account is better suited to your goals. A stock brokerage account on the other hand is ideal if you want to trade stocks or other securities.
Allocate Your Assets
Asset allocation is an important part of building a solid investment portfolio. Asset allocation refers to the percentage of each asset you hold in your portfolio. Choosing the right assets and allocating them for your portfolio depends on factors like:
- Your expectations
- Your investment time horizon
- Your risk profile
Some of the assets you may include in your portfolio are:
- Stocks (you can invest directly in individual stocks or indirectly through mutual funds, index funds, or ETFs).
- Mutual funds
If you are building your portfolio from scratch, look for model portfolios that show you how other investors with different risk tolerance construct their portfolios.
Evaluate and Rebalance Your Investment Portfolio as Needed
Your investment portfolio is not set in stone. It evolves as you gain more experience and with changing market conditions. Evaluating your portfolio regularly (experts recommend every six to twelve months) allows you to know when you are taking too much risk that you can handle or are leaving opportunities on the table.
When you track your investment portfolio regularly, you can correct your course in good time and allow you to remain on track to achieving your investment goals.
Whether or not you are a beginner in investing, building and maintaining a good portfolio is the key to meeting your financial goals. A good investment portfolio means different things to different people, but it should align with your risk profile, your investment horizon, and your overall financial goals.
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