How To Build Your Investment Portfolio
Building your investment portfolio is the trickiest part of investing. But it’s also the most fun part. Because now you combine your investment objectives, risk tolerance, and investment style to a solid strategy.
7.1 Why You Need A Plan For Your Investment Portfolio
You’ll want to have mapped out all these elements before you start investing. It might take a little while, but it will greatly reduce the chances of catastrophic doom and failure.
Doom and failure? Isn’t this a little melodramatic?
Maybe. But first imagine you made an investment without thinking about when you would need your money back. In other words, your objective wouldn’t be clear. Not the best approach, but you want the shiny returns so you take the risk and make an investment. A whole year later, nothing bad has happened; you haven’t spontaneously combusted, been struck by lightning, or watched your investment vanish into thin air. In fact, your investment is doing quite well. You’re happy.
And then your car breaks down. You need some cash. But before you can it out of your investment, Greece goes broke and the financial markets turn into a mess. The value of your investments drop by 30%. You still need the money back, so you have to sell a great deal of your investments at this low price.
The problem is that they’re not very liquid. This means you take even further losses in trying to sell them. D’oh!
Now you’ve cashed your investments in when they were at the lowest value you’ve ever seen them, you aren’t able to buy that lovely Audi you had your eye on. But it is still possible to replace your broken-down car. And who knows? You might find a reason to be happy about driving a Citroën.
The lesson is that you don’t want to invest blindly. Think carefully. Do your homework. And be clear about why you’re doing investing. If you knew in advance that you would have to buy a new car in the near future, you could either have put the money aside, or you could’ve made a less risky, more liquid investment.
Of course, this isn’t the only potential problem. In response to the scenario above, you might decide to be super-conservative so your capital won’t be able to disappear. And only into highly liquid assets. Clever! You only invest capital you’re sure you won’t need before you retire. What a plan! Unfortunately, you still lose. These low-risk investments also have low returns. As a result, when it’s time to retire, you have enough to live on, but the new holiday house in the mountains that you always wanted is definitely outside your price range.
Think carefully about your objective. Especially since different objectives require different strategies. Be clear about what you want, the risk you’re comfortable taking and the style and level of involvement that will work best for you. Put everything together. Make any adjustments or corrections you need to. Then, and only then, make your investment.
7.2 How To Start Building Your Investment Portfolio
What is the best place to start? If you’ve decided on your investment objectives, risk tolerance and investment style, you’re ready to take the next steps. If you haven’t already, go back through the guide and have a good read. Make a few notes and make sure you’re ready to continue.
And if you have done that, you’ll have four decisions to make:
1. Product: Which products would you like to invest in?
2. Diversification: How many products do you want to invest in?
3. Allocation: How do you allocate these products in your portfolio?
4. Amount: How much capital do you invest now and in the future?
You’ll find there’s an endless range of products available for you to invest in. Chapter 3 gives you a brief overview of the most common types of investments. A huge percentage of them probably won’t interest you at all. Because on one level, mashed soybean meal is about as interesting as watching grass grow. But these subjects are far more exciting from an investment perspective. And this is the perspective you have to take here. Will these investments allow you to realise your objectives? And do they suit your investment style?
There’s a very important question for you to solve here. Are you investing to build up capital? It allows you to enjoy retirement, build a house or pay for an education for your children. And if you use your investment to create an income? You might supplement your income. Or it could be to replace it completely. Don’t deny how cool it would be cool to replace working with sleeping in late in the mornings. Win.
It doesn’t matter if you’ve picked single shares or funds. You can either focus on growth or creating income with both. We look at the difference more closely below.
Your investment style influences the products you’re going to invest in. The first question you need to ask yourself is whether you’re interested in being highly active. Do you want to research single stocks and bonds? Do you have the time to do all this? And do you have the interest required? You might find your lifestyle is better suited to a more diversified approach involving funds and ETFs. It’s sure to save you plenty of time, energy, stress and doubts.
And it offers a more diversified approach.
No matter what your investment style, you’ll always want to delve into different asset classes. Investing in different asset classes helps you to manage investment risk. Again, you might choose to buy single bonds and shares of companies, or you might invest in equities and bonds through funds and ETFs. Both are possible.
But there’s no need to restrict yourself to just two different classes. Take a look at other asset classes. For example? A Real Estate Investment Trust (REIT). You might also decide to add some precious metals, such as gold, to your portfolio. This is great for diversity. And the more you diversify, the better balanced your portfolio is. It’s wonderful for helping you stay on top through the good times and the bad times.
Bob decides to keep a small stake in Gin Co. But he also purchases interests in Whiskey Co. and Vodka Co. But he doesn’t stop here. Bob isn’t happy that all his investments are in alcoholic drinks. It doesn’t seem diverse enough. Especially now that there is such a strong trend towards physical health. Bob decides to diversify his investments by investing in a fund that focuses solely on superfoods and re-investing in Lazy Name Co.
After this, he also decides to invest in some government bonds. They will not mature for a period of three years. Bob feels more comfortable with a part of his capital invested in such a low-risk investment. But this isn’t the only reason for the bonds. Bob doesn’t see any other investment opportunities that interest him at the moment. By investing in bonds, he still has his money working for him while he patiently researches other potential investment opportunities.
Growth stocks vs. dividend stocks
We differentiate between growth stocks and dividend stocks. Growth stocks are companies that usually invest a big part of their profits into their future growth. Your money grows as the company grows. You hope to sell your shares at an enormous profit.
Other businesses, especially the very big ones, often prefer to pay a large proportion of the profits to their shareholders in the form of dividends. This is a great way for creating income.
Growth funds vs. income funds
You’ll find the same possible with funds. There are funds that reinvest profits to pursue growth while others allow you to create an income. How do you know which ones are which? The funds will tell you. They usually mention it in their prospectus. Take a look and you’ll find all the information you need.
Accumulating ETFs vs. distributing ETFs
Exchange Traded Funds (ETFs) do not have investment managers who pursue specific strategies. They just follow an index. However, there are ETFs that keep reinvesting dividends, just as there are ETFs that pay out their returns to the benefit of their investors. The name for the first type? Accumulating ETFs. The others are called Distributing ETFs.
7.3 Portfolio Diversification
You’ve now decided on the type of investment products that is best suited to your needs. And you’ve made sure that your investment products are in line with your objectives and investment style.
But now the big question. How many of these products do you include in your portfolio?
Mutual funds and ETFs
Let’s start off with a simple answer. This is one where you decide you like mutual funds and ETFs. Why is this the simple answer? Because a lot of these products are available with ready-made portfolio strategies. For example, Vanguard has a product called a Life Strategy Fund. It’s basically a portfolio that consists of different equity and bond funds. In other words, it’s a fund made of funds. And the funds it invests in are very diverse. This means the homework on diversity is already done for you. You only need to buy this single product and you’re ready to go.
Often, they come with different risk levels as well. So, you could pick the risk level you feel comfortable with.
It might sound perfect! And it could be. But it doesn’t offer you very much in the way of control of the ability to steer where your capital goes. In other words, you’ll have little say over what happens to the money you’ve invested. Is this important to you? You’ll have to decide.
Lastly, keep watching the fees. Your fund manager might already charge a lot. But as he will invest into other funds as well, you’ll pay double.
Equity and bond fund
Do you want to have steering possibilities? You might want to buy a very well diversified equity and bond fund. This would be something like an all-world equity fund, and an all-world bond fund. It means you’ll have invested in just two products, but these products have a lot of diversification within them. And you’ll be able to define how you want your capital allocated. This gives you an opportunity to steer the risk of your investments.
This probably sounds pretty simple. It is. You might even think it sounds too simple. And for a lot of people, it is. After all, an all-world equity fund might not tick all the boxes you have; it may not meet your ethical concerns for example. You may want to look for a potentially less diverse fund that is assured of meeting certain ethical concerns.
Alternately, you might be more interested in and supportive of the biotechnology sector or the semiconductor industry. You’ll most likely be able to find a well-diversified fund focused on these or any other topic. Of course, you may choose to split your all-world bond fund into a global corporate bond fund and a European government fund.
The diversification rule
Now, here’s the rule. It’s quite general, but you’ll still want to pay attention to reduce risk. The narrower the focus of a certain fund, the more products you should include in your portfolio. You might invest in three to six equity funds and complement this investment with investments in two to four bond funds. It gives a decent level of diversification. And this diversification reduces your risk.
It’s not the only solution. If you’re feeling extra motivated, you may want to go further and choose the specific companies you want to invest in. And pick the specific bonds you believe in most. It’s a lot of research and it’s very time consuming, but at the end of the day, it saves you the fees and costs you would otherwise have to pay out for fund management. It also gives you a say on each and every detail of your investment strategy. Just remember to look at the transaction costs. They might add up if you invest lower amounts.
You’ll still want to diversify here. Betting on just a couple of companies puts your capital in a very dangerous position. The more companies, industries and sectors, the better the diversification and the less risk you’re facing. After all, it’s possible for an entire sector to effectively roll over and die. You’ll find plenty of investments websites and advisors who encourage you to choose at least 20 companies, from diverse industries and sectors, and 5 different bond issuers. If you’ve chosen them wisely, you’ll be courting far less risk on your path to future success.
7.4 Asset Allocation
You’ve now defined the kind of investment products you want to invest in. The next question to answer? How much you should invest in each product. How should you allocate your assets?
Asset allocation is extremely important when investing. It’s your main tool for managing investment risk and reward.
Your investment allocation helps in engineering your portfolio towards a certain level of risk. You’ll need to decide what this level of risk is. However, you’re also building a portfolio that targets a specific objective. And this objective comes with its own level of risk. Other portfolios with different objectives may entail a very different risk level.
Do you remember what you’ve learned about risk tolerance earlier in the guide? Risk tolerance consists of your ability and your willingness to take risks. You need to decide now how much of your capital you can potentially lose. This is based on your financial situation as well as your ability to lose capital and still sleep well at night.
Now it’s time to recall the results of your assessment. Have you crunched the numbers? Can you afford losing 30%? Or does this take your breath away? What if you lose 20% of your invested money? Are you still able to pay your rent? Think carefully, because you need to be able to take the hit.
You’re investing to achieve a certain objective. And this objective comes with its own level of risk. You may want to take more risk when you’re investing for your holiday house, compared to when you’re investing for your children’s education.
And the longer your investment horizon, the more risk you’re able to take. Because you’ll have more time to bounce back (and in theory, less capital to lose). Let’s say you’ll only need your capital twenty years from now. You’ll have time to go through multiple financial crises and not have to worry about the huge losses you’ll face on the road.
Why? Because the markets will grow in the long run. As you approach the end of your investment, you’ll want to reduce the risk. This will mean the ride to the end is a lot smoother.
Of course, this is with a long investment. But suppose you don’t have a couple of decades up your sleeve? You won’t have the time to bounce back from a financial crisis.
Imagine you have a couple of years left before you retire. But you want to keep building your wealth nonetheless. You’ll need to live from the income of these investments in a couple of years from now. So, you have to be extremely well prepared in advance and avoid taking too much risk.
You’ve already decided on the number of assets you’ll invest in. You know the amount of risk that you’re willing to take. And you’re aware of the investment horizon of your investment objective. Now it’s time to put the pieces together.
A simple way to do this is to look at model allocations and their expectations in relation to risk and return.
Very high risk-and-return allocation:
- Allocation: 90% equity, 10% fixed income
- Risk: high
- Long-term gain: 8%
- Short-term loss: 25%
- Suitable investment horizon: 15 years
Medium risk-and-return allocation
- Allocation: 50% equity, 50% fixed income
- Risk: medium
- Long-term gain: 6%
- Short-term loss: 20%
- Suitable investment horizon: 10 years
Low risk-and-return allocation
- Allocation: 30% equity, 70% fixed income
- Risk: low
- Long-term gain: 4%
- Short-term loss: 15%
- Suitable investment horizon: 5 years
Very low risk-and-return allocation
- Allocation: 10% equity, 90% fixed income
- Risk: very low
- Long-term gain: 2%
- Short-term loss: 10%
- Suitable investment horizon: 3-5 years
Deciding on the right allocation
You now know all the pieces you’ll have to puzzle together when you develop your portfolio. First, have a look at the period of investment. This is often called the investment horizon or time horizon. It’s basically how long you have before you want to (or have to) reach your objective. It’s a good idea to take a look at the corresponding risk in the table above.
If the risk is below your risk tolerance, then you have a green light for the specific allocation. But if the risk is higher than your risk tolerance? It’s time to look at those less risky portfolios. Move down in the list until you find the portfolio that has a risk level below your risk tolerance. That’s the allocation you want. It will make sure you keep sound finances and let you sleep well during at night. Yes, even though the markets are sure to go wild from time to time.
Once you’ve chosen your model allocation, it’s time to put your equity products in the equity part and your fixed-income products in the other part.
Within the equity and the fixed-income part you may want to allocate each product equally. Or you might decide to increase the parts of the products you believe in more.
Of course, this kind of approach is very basic. More refined theories about allocating your assets exist too. For example, it’s possible to invest into something more than just equities and fixed income. You could also add real estate and precious metals to your portfolio.
Plus, you could apply financial models such as the Modern Portfolio Theory to squeeze the maximum amount of returns out of your portfolio. But these techniques will require some more dedication. For now, it’s good to keep things simple and to apply more advanced techniques on the way.
7.5 Investment Amount
You’re nearly there! You’ve now decided which products you want to invest in, you’ve included sufficient assets to ensure strong diversification and you’ve applied an allocation plan that meets your investment objective and risk tolerance.
Now it’s time for the big question. How much do you invest?
For the most part, this will depend on your investment objective. Or in other words, the amount of capital you’re able to spare and invest when you start, as well as the amount you’re able to reinvest periodically.
It’s best not to think about your investment as being just one big lump sum that you invest in the beginning. Instead, it’s better to put away a lot of smaller amount over a very long period of time.
And always try to ignore the market noise. Whether markets are up or down, keep reinvesting. This way, you minimise your chances of buying when prices are high.
Investing just before a market correction would be unfortunate. If you keep reinvesting no matter what, you’ll most likely pay an average price for your assets. Not too high. Not too low. Just right. This technique is called Dollar-Cost-Averaging (DCA) and is popular among investors.
Congratulations! You’ve built your investment portfolio. Now it’s time to start managing your investments.
7.6 Additional Reading
This guide is for educational purposes only, and should not be seen as financial advice.
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