Structuring An Investment Portfolio: Strategies For Success

An investment portfolio is a collection of invested assets such as stocks, bonds, funds, and real estate. The right mix of assets is key to long-term returns. This involves determining your risk tolerance, investment timeframe, and rebalancing. Diversification is important, choosing asset classes that are not correlated with each other to provide stability. Your portfolio should also align with your investment goals, whether it's for retirement, a down payment on a home, or a child's college fund. You can choose to manage your portfolio yourself or outsource it to a robo-advisor or financial advisor.

Risk profile: Are you comfortable with risk or do you prefer stability?

Risk tolerance is a key consideration when structuring an investment portfolio. An individual's risk profile outlines their willingness to take risks with their investments and their ability to take on debt. This is integral in determining the asset allocation in their investment portfolio.

An investor with a high-risk tolerance may be comfortable with investing in unproven or lesser-known companies or alternative investment options with high growth potential. They are willing to sacrifice stability for higher returns. These investors tend to be more comfortable with risk and have a longer time horizon, meaning they can weather potential losses in the short term for greater potential gains in the long term.

On the other hand, an investor with a low-risk tolerance will typically opt for more stable and proven investments, such as blue-chip stocks, bonds, CDs, and money market funds. These investments offer lower but more consistent returns. Investors with a low-risk tolerance prefer stability and are often those who are closer to retirement or have financial goals that require a more conservative approach.

It's important to note that an individual's risk profile can change over time as their financial situation, goals, and time horizon evolve. For example, an investor may become more risk-averse as they approach retirement to preserve their capital and ensure a stable income.

Additionally, a person's risk profile can also impact their ability to take on debt. Lenders will assess an individual's risk profile when determining their eligibility for a loan or credit card. This includes evaluating their debt-to-income ratio, credit score, and payment history. A low-risk profile indicates a higher likelihood of approval for credit, while a high-risk profile may lead to higher interest rates or lower credit limits.

Investment timeframe: When will you need the money?

When structuring an investment portfolio, it is crucial to consider your investment timeframe and when you will need the money. This timeframe will influence your investment strategy and the level of risk you are willing to take.

The investment time horizon refers to the period you expect to hold an investment before needing the money back. This horizon is dictated by your investment goals and strategies. For instance, saving for a down payment on a house within two years is a short-term time horizon, while saving for college is a medium-term horizon, and investing for retirement is a long-term horizon.

Short-term investment horizons typically refer to investments expected to last fewer than five years. These are suitable for individuals approaching retirement or those needing a large sum of cash in the near future. Money market funds, savings accounts, certificates of deposit, and short-term bonds are common choices for short-term investments as they can be easily liquidated into cash.

If your investment timeframe is medium-term, you can expect to hold the investment for three to ten years. This timeframe is often associated with people saving for significant life events such as buying a home, marriage, or a child's education. Medium-term investment strategies balance high- and low-risk assets, so a combination of stocks and bonds can help protect your wealth while preserving value against inflation.

Long-term investment horizons are for those who plan to hold investments for ten or more years, with retirement savings being the most common example. Long-term investors are generally willing to take on greater risks in exchange for greater rewards. The longer time horizon allows for more aggressive investment strategies and provides more opportunity to recover from any market downturns.

Understanding your investment timeframe is crucial as it helps you make informed decisions about the types of investments to choose and the level of risk you can tolerate. It ensures that your investment strategy aligns with your financial goals and that you are not taking on unnecessary risks.

Diversification: Choose uncorrelated asset classes

Diversification is a crucial aspect of structuring an investment portfolio. The key idea is to choose asset classes that are not correlated with each other. This means selecting assets that move in different directions and at different times. By doing so, you can create stability in your portfolio.

When choosing uncorrelated asset classes, consider selecting assets from different categories, such as shares, property, bonds, and cash. Shares and property are considered "growth" assets, but their market values tend to fluctuate independently of each other. Combining these assets can reduce overall volatility. Additionally, including defensive" assets like bonds and cash can further stabilise the volatility of your portfolio.

It's important to remember that diversification can have its downsides. While it can help reduce risk and volatility, it may also limit your potential returns. A diversified portfolio is more likely to mirror the market average, and managing multiple investments can be time-consuming.

To effectively diversify, you should determine your risk tolerance and investment goals. Younger investors with a higher risk tolerance can afford to allocate a larger portion of their portfolio to equities, while older investors nearing retirement may opt for more conservative asset allocations to protect their capital.

Additionally, consider the different subclasses within each asset class. For example, when investing in equities, you can divide your portfolio between different industrial sectors, market capitalisations, and domestic and foreign stocks. Similarly, when investing in bonds, you can choose between short-term and long-term bonds, government debt, or corporate debt.

By choosing uncorrelated asset classes and considering the various subclasses, you can build a well-diversified portfolio that aligns with your investment goals and risk tolerance.

Rebalancing: Regularly review and adjust your portfolio

Regularly reviewing and adjusting your investment portfolio is essential to ensuring it remains aligned with your financial goals and risk tolerance. Here are some detailed insights on rebalancing your portfolio:

Reviewing Your Portfolio

Markets are dynamic, and your investment portfolio should be periodically reviewed to ensure it meets your desired level of return and aligns with your risk appetite. This process involves evaluating your asset allocation and making necessary adjustments. It is generally recommended to review your portfolio annually to strike a balance between active management and long-term investment.

Understanding Rebalancing

Rebalancing is the process of restoring your investment portfolio to its original composition. Over time, the value of your investments will fluctuate, causing your chosen asset allocation to deviate from your initial plan. For example, if one of your stocks performs exceptionally well, it may come to dominate a larger proportion of your portfolio than intended, increasing the overall risk.

When to Rebalance

There are different approaches to determining the optimal time to rebalance. Some advisors suggest rebalancing at fixed intervals, such as every six or twelve months. Another strategy is to monitor your portfolio and initiate rebalancing when the allocation of a specific asset class, such as stocks, deviates from your plan by a predetermined percentage, often around 5%.

Strategies for Rebalancing

When rebalancing, you can sell a portion of your overweighted securities and use the proceeds to invest in other underweighted asset classes. It is important to consider the tax implications of selling assets, as capital gains taxes may apply. Alternatively, you can adjust your future contributions, directing them towards underweighted asset classes to restore balance gradually.

Benefits of Regular Rebalancing

Regular rebalancing helps maintain your desired level of risk and return. It also provides an opportunity to reassess your financial situation, goals, and risk tolerance, making any necessary adjustments to your investment strategy.

Remember, investing carries inherent risks, and there is no one-size-fits-all approach to structuring an investment portfolio. Always conduct thorough research and, if needed, consider seeking advice from a qualified financial professional.

Investment policy statement: Outline your investment objectives, risk tolerance and time horizon

An investment policy statement (IPS) is a strategic document that outlines guidelines for achieving a client's investment goals. It is a formal agreement between a client and a financial advisor, outlining how the advisor will meet the client's investment goals. It is tailored to the client's specific financial and investment details and the advisor's costs.

The IPS lays the foundation for the client-financial advisor relationship and details how the financial advisor will make investment decisions. It can be a useful tool to prevent emotions from driving unwise investment decisions during financially turbulent times.

The IPS should include the client's broad investing goals and objectives, as well as the path the advisor will take to reach these goals in collaboration with the client. This includes topics such as asset allocation, risk tolerance, and financial goals.

For example, an IPS may state that an individual wants to have the option to retire by the time they are 60 years old, with their portfolio returning $65,000 annually, adjusted for inflation. It may also specify the target allocation between stocks and bonds, with minimum and maximum deviations that will trigger portfolio rebalancing.

The IPS should also give attention to the investor's risk/return profile, including asset classes to be avoided or preferred. It should include all current account information, current allocation, the amount currently being invested, and the amount accumulated.

Additionally, the IPS should establish monitoring and control procedures, including the frequency of monitoring, benchmarks for comparison, and procedures for making any future changes to the IPS.

Frequently asked questions