How To Make Your Portfolio Invest Itself

Building an investment portfolio can be intimidating, but it doesn't have to be. A portfolio is a collection of invested assets such as stocks, bonds, funds, real estate, and even cryptocurrency. The first step to building a portfolio is to determine your risk tolerance and time horizon, which will inform how your assets are allocated. You can then choose an account or advisor and select investments that align with your preferences and goals. It's important to regularly revisit and rebalance your portfolio to ensure it stays on track. While you can build a portfolio yourself, you can also outsource this task to a robo-advisor or financial advisor.

Risk tolerance

Aggressive investors have a high-risk tolerance and are comfortable taking bigger risks to pursue potentially larger returns. They are typically willing to invest heavily in stocks, with a smaller allocation to safer assets like bonds. Younger investors often fall into this category, as they have more time to recover from any market downturns.

Moderate investors seek a balance between risk and reward. They aim for growth while being cautious of significant losses, usually opting for a portfolio that includes a mix of stocks and bonds.

Conservative investors prefer to minimise risk and favour investments that protect their original capital. They tend to invest in less volatile assets like bank certificates of deposit (CDs), money markets, or U.S. Treasuries. Retirees or those approaching retirement age often exhibit conservative risk tolerance as they seek to preserve their principal investments.

It is important to note that risk tolerance can change over time due to various factors, including age, income, investment goals, and market conditions. Therefore, investors should periodically reassess their risk tolerance to ensure their investment strategies align with their financial objectives and comfort level with risk.

To determine one's risk tolerance, individuals can consider factors such as their financial goals, time horizon, comfort with short-term losses, the presence of non-invested savings, and their willingness to take on more risk for potentially higher returns. Online risk tolerance questionnaires are also available to provide guidance.

Asset allocation

Your time horizon refers to the length of time you plan to invest before achieving a particular financial goal. If you have a longer time horizon, you may feel more comfortable taking on riskier investments. Conversely, a shorter time horizon may prompt you to opt for less risky investments.

Risk tolerance refers to your ability and willingness to potentially lose some or all of your original investment in exchange for greater potential returns. An aggressive investor with a high-risk tolerance is more likely to risk losing money to achieve better results. On the other hand, a conservative investor with low-risk tolerance tends to favour investments that preserve their original investment.

There are three main asset classes: equities, fixed income, and cash and cash equivalents. Each class has different risks and return potential, so they behave differently over time.

Equities include common stock, preferred stock, mutual funds, and exchange-traded funds (ETFs). These can generate dividend income or be non-dividend payers, such as growth stocks. Fixed-income investments include corporate bonds, municipal bonds, and Treasury bonds, as well as mortgage loans, bridge loans, and other debt instruments with fixed-rate income payments. Cash and cash equivalents are the safest investments but offer the lowest returns. They include savings deposits, certificates of deposit, treasury bills, money market accounts, and money market funds.

There is no one-size-fits-all asset allocation strategy. It needs to be tailored to your personal circumstances. However, some general guidelines can help you determine the right mix.

The "100 minus age" rule is a popular guideline, suggesting that the percentage of your portfolio invested in stocks should be 100 minus your age, with the remainder in bonds and safer assets. For example, a 30-year-old would invest 70% in stocks and 30% in bonds. This rule can be adjusted based on your individual goals and risk tolerance.

Another approach is to categorise portfolios based on risk profiles, ranging from conservative to very aggressive. A conservative portfolio focuses on lower-risk securities such as fixed-income and money market securities, aiming to protect the principal value. A moderately conservative portfolio may use a "current income" strategy, choosing securities that pay high dividends or coupon payments. A moderately aggressive or balanced portfolio is divided almost equally between fixed-income securities and equities, balancing growth and income. An aggressive portfolio primarily consists of equities, aiming for long-term capital growth, while a very aggressive portfolio is almost entirely stocks, pursuing strong capital growth over a long time horizon.

It's important to regularly review and adjust your asset allocation to ensure it aligns with your changing financial goals and circumstances.

Diversification

How to Diversify Your Portfolio

• Spread the Wealth: Diversify your investments across different asset classes such as stocks, bonds, real estate, or cryptocurrency. You can also invest in different countries, industries, company sizes, or term lengths for income-generating investments.
• Consider Index or Bond Funds: Add index funds or fixed-income funds to your portfolio. These funds track various indexes and can provide diversification over the long term.
• Keep Building Your Portfolio: Regularly add to your investments using dollar-cost averaging to smooth out market volatility.
• Know When to Get Out: Stay informed about your investments and overall market conditions to know when to cut your losses and sell.
• Keep an Eye on Commissions: Understand the fees you are paying and what you are getting in return.

Benefits of Diversification

Drawbacks of Diversification

When Not to Diversify

Additionally, over-diversification can increase overall portfolio risk and lower expected returns. This can happen when there are too many securities in a portfolio or if closely correlated securities are added.

Rebalancing

Over time, the market value of each security within your portfolio will earn a different return, resulting in a weighting change. This will inevitably change the risk profile of your portfolio. For example, if you had initially decided to invest equally in stocks and bonds, over time, the stock portfolio might perform well and be valued higher than the bond portfolio, resulting in a higher concentration of stocks than bonds. Rebalancing your portfolio to achieve the original 50/50 split would require you to either sell some stocks or buy some bonds until the value of each asset class is equal.

There are two main approaches to rebalancing:

• Calendar-based rebalancing: This approach adjusts your portfolio on a regular timetable, such as quarterly or annually. It is simple to implement but may be out of sync with the actual changes in your portfolio's asset allocation.
• Trigger-based rebalancing: This method is triggered when a portfolio drifts beyond certain pre-determined limits, for example, if an asset class changes by 10% or more relative to its target allocation. It promptly rebalances when the portfolio drifts too far from its predetermined asset allocation goal but may be more difficult to implement.

The frequency of portfolio rebalancing depends on various factors, such as age, risk tolerance, and transaction costs. It is generally recommended to rebalance at least once a year, although some professionals suggest doing it every quarter. However, if you are relatively young, you might not want to rebalance as frequently as someone nearing retirement, who needs to maximise their gains.

When rebalancing, it is important to be mindful of the taxes incurred when selling profitable investments. To minimise transaction costs and taxes, you could opt to partially rebalance your portfolio or focus on shares with a higher cost basis. Alternatively, you can place your portfolio in a tax-advantaged account, such as an individual retirement account (IRA), and avoid taxes until you start withdrawing from the account.

Investment accounts

Types of Investment Accounts

There are several types of investment accounts available, each serving a specific purpose:

• Retirement Accounts: These include 401(k) plans and Individual Retirement Accounts (IRAs). They offer tax advantages to encourage savings for retirement. For example, traditional 401(k)s and IRAs provide tax deductions when contributing, while Roth 401(k)s and Roth IRAs offer tax-free withdrawals in retirement.
• Taxable Brokerage Accounts: These accounts are suitable for non-retirement financial goals, such as saving for a down payment on a house. They provide flexibility by allowing access to your money at any time without early withdrawal penalties.

Choosing the Right Investment Account

When selecting an investment account, consider your financial goals and time horizon. If you're primarily saving for retirement, a tax-advantaged retirement account like a 401(k) or IRA is a wise choice. On the other hand, if you have shorter-term goals, a taxable brokerage account might be more appropriate.

Additionally, evaluate the fees and expenses associated with each type of account. Some accounts may have management fees or transaction costs that can impact your overall returns.

Monitoring and Adjusting Your Investment Accounts

Once you've chosen your investment accounts, regularly monitor their performance. Review your accounts' diversification and rebalance them periodically to maintain your desired asset allocation. Diversification across different investment types and industries helps protect your portfolio from significant losses and provides a smoother investment journey.

Remember, investing involves risk, and there is no one-size-fits-all approach. Always assess your personal financial situation, risk tolerance, and goals before making any investment decisions.

Frequently asked questions