Crafting A Portfolio: Your Investment, Your Purpose

An investment portfolio is a collection of financial assets, such as stocks, bonds, commodities, cash, and cash equivalents, including closed-end funds and exchange-traded funds (ETFs). The purpose of an investment portfolio is to provide a framework for your money and help you manage your investments. It enables you to diversify your assets and spread your risk across different types of investments. By understanding your risk tolerance, investment objectives, and time horizon, you can assemble and adjust your portfolio to align with your financial goals. Portfolios can be managed actively or passively, aiming to maximise returns and balance risk. Ultimately, the goal of an investment portfolio is to grow your wealth over time and achieve your financial objectives.

Risk tolerance

An investor with a high-risk tolerance may be comfortable with a more aggressive portfolio, which assumes greater risks in search of greater returns. These investors often seek out companies in their early growth stages, which tend to experience higher price fluctuations. On the other hand, investors with a low-risk tolerance would opt for a more conservative or defensive portfolio, focusing on consumer staples or mature companies with stable performance.

Additionally, risk tolerance plays a role in the time horizon of investments. Investors with a higher risk tolerance may be comfortable investing their entire portfolio in stocks, even if they are closer to retirement, as they are willing to ride out short-term market volatility. In contrast, those with a lower risk tolerance may shift towards more conservative assets, such as bonds and cash, as their retirement date approaches to protect their earnings.

Understanding one's risk tolerance is crucial for effective portfolio management. It helps investors make informed decisions about the level of risk they are comfortable with and guides their investment choices, ensuring their portfolio aligns with their financial goals and personality.

Time horizon

For example, an investor saving for retirement with a five-year time horizon might opt for a more conservative portfolio, investing a larger portion of their assets in bonds and cash to protect what they have already saved. Conversely, an individual with a decades-long time horizon may choose to invest their entire portfolio in stocks, as they have the time to ride out short-term market volatility.

In general, portfolios with a shorter time horizon should be less risky, whereas those with a longer time horizon can take on more risk. However, this does not mean that investors with long time horizons should make extremely risky trades. Instead, they may hold riskier types of equities, such as mid-cap, small-cap, or high-growth stocks.

Diversification

There are several approaches to diversifying a portfolio:

• Distributing investments across a wide range of vehicles, including cash, stocks, bonds, mutual funds, ETFs and other financial instruments. It is important to seek out assets whose historical returns have shown little correlation, meaning they move independently of each other. This ensures that while one part of the portfolio may shrink, others could grow.
• Maintaining diversity within each asset category. For stocks, this means including securities that vary by sector, industry, geographic region and market capitalisation. A similar approach can be applied to bonds by varying maturities and credit qualities.
• Investing in securities with different risk profiles. Including investments with varying levels of risk and potential returns can help balance a portfolio. This allows for the possibility that significant gains in higher-risk areas may offset losses in more stable investments.

While diversification is a key strategy for managing risk, it is important to note that it does not guarantee against loss. However, it is an important tool for insulating the portfolio from the poor performance of any single investment or market sector.

Asset allocation

Time Horizon

The time horizon refers to the expected duration of your investment journey, which can be measured in months, years, or decades. It is influenced by your specific financial objectives. For instance, an investor saving for a teenager's college education has a shorter time horizon compared to someone investing for retirement. Those with a longer time horizon tend to be more comfortable taking on riskier investments as they can navigate the ups and downs of the market over an extended period.

Risk Tolerance

Risk tolerance pertains to your capacity and willingness to endure potential losses on your investments. It is a critical aspect of asset allocation, as different assets carry varying levels of risk. Aggressive investors, or those with a high-risk tolerance, are inclined to take more significant risks in pursuit of higher returns. Conversely, conservative investors, or those with a low-risk tolerance, tend to prioritize capital preservation and opt for investments with lower risk.

Diversification

Diversification is a key strategy in asset allocation, encapsulated in the adage "don't put all your eggs in one basket." It involves spreading your investments across different assets, industries, and sectors to reduce risk. By diversifying, you lower the likelihood of incurring substantial losses as different assets perform differently under varying market conditions. Diversification also helps smoothen the overall investment returns of your portfolio.

Rebalancing

Over time, your portfolio may drift away from your original asset allocation due to the varying performance of different investments. Rebalancing involves adjusting your portfolio to restore the desired asset allocation mix. This process ensures that your portfolio remains aligned with your investment goals and risk tolerance. You can rebalance by selling overweighted investments and using the proceeds to buy underweighted assets, or by simply buying new investments for underweighted categories.

Lifecycle Funds

Lifecycle funds, also known as target-date funds, are a type of diversified mutual fund designed for investors who prefer a simplified approach. These funds automatically adjust their asset allocation mix to become more conservative as they approach a predetermined target date. The target date is typically aligned with the investor's goal, such as retirement or a specific savings target.

Investment turnover

There are two main ways to calculate investment turnover. One method involves looking at the total value of new securities purchased during the period, and dividing this by the value of the portfolio. The other method involves identifying the value of any securities sold during the period, and dividing this figure by the net value of the portfolio.

The benefit of assessing investment turnover is that it allows investors to understand the value of their current investment strategies, and whether their approach to buying and selling securities is helping them achieve their goals. If not, they may decide to try a different approach to acquiring, holding, and selling assets.

There is no ideal turnover ratio that suits all investors. A ratio that is acceptable to a conservative investor may be seen as a failure by someone who is more risk-tolerant. The purpose of calculating investment turnover is to determine whether the activity is in line with the investor's mindset and preferences, and to assess whether their buying and selling strategies can be improved to increase benefits.

Frequently asked questions