4 Steps to Building a Profitable Portfolio (From Investopedia.com) [2 Articles]
~ Sunday, December 18, 2022 Blog Post ~
ARTICLE #1 By Chris Gallant
A well-diversified portfolio is vital to any investor’s success. As an individual investor, you need to know how to determine an asset allocation that best conforms to your personal investment goals and risk tolerance. In other words, your portfolio should meet your future capital requirements and give you peace of mind while doing so. Investors can construct portfolios aligned to investment strategies by following a systematic approach. Here are some essential steps for taking such an approach.
KEY TAKEAWAYS
- Overall, a well-diversified portfolio is your best bet for the consistent long-term growth of your investments.
- First, determine the appropriate asset allocation for your investment goals and risk tolerance.
- Second, pick the individual assets for your portfolio.
- Third, monitor the diversification of your portfolio, checking to see how weightings have changed.
- Make adjustments when necessary, deciding which underweighted securities to buy with the proceeds from selling the overweighted securities.
Step 1: Determining Your Appropriate Asset Allocation
Ascertaining your individual financial situation and goals is the first task in constructing a portfolio. Important items to consider are age and how much time you have to grow your investments, as well as the amount of capital to invest and future income needs. An unmarried, 22-year-old college graduate just beginning their career needs a different investment strategy than a 55-year-old married person expecting to help pay for a child’s college education and retire in the next decade.
A second factor to consider is your personality and risk tolerance. Are you willing to hazard the potential loss of some money for the possibility of greater returns? Everyone would like to reap high returns year after year, but if you can’t sleep at night when your investments take a short-term drop, chances are the high returns from those kinds of assets are not worth the stress.
Clarifying your current situation, your future needs for capital, and your risk tolerance will determine how your investments should be allocated among different asset classes. The possibility of greater returns comes at the expense of greater risk of losses (a principle known as the risk/return tradeoff). You don’t want to eliminate risk so much as optimize it for your individual situation and lifestyle. For example, the young person who won’t have to depend on his or her investments for income can afford to take greater risks in the quest for high returns. On the other hand, the person nearing retirement needs to focus on protecting their assets and drawing income from these assets in a tax-efficient manner.
Conservative vs. Aggressive Investors
Generally, the more risk you can bear, the more aggressive your portfolio will be, devoting a larger portion to equities and less to bonds and other fixed-income securities. Conversely, the less risk you can assume, the more conservative your portfolio will be. Here are two examples, one for a conservative investor and one for the moderately aggressive investor.
The main goal of a conservative portfolio is to protect its value. The allocation shown above would yield current income from the bonds, and would also provide some long-term capital growth potential from the investment in high-quality equities.
Step 2: Achieving the Portfolio
Once you’ve determined the right asset allocation, you need to divide your capital between the appropriate asset classes. On a basic level, this is not difficult: equities are equities and bonds are bonds.
But you can further break down the different asset classes into subclasses, which also have different risks and potential returns. For example, an investor might divide the portfolio’s equity portion between different industrial sectors and companies of different market capitalizations, and between domestic and foreign stocks. The bond portion might be allocated between those that are short-term and long-term, government debt versus corporate debt and so forth.
There are several ways you can go about choosing the assets and securities to fulfill your asset allocation strategy (remember to analyze the quality and potential of each asset you invest in):
- Stock Picking — Choose stocks that satisfy the level of risk you want to carry in the equity portion of your portfolio; sector, market cap, and stock type are factors to consider. Analyze the companies using stock screeners to shortlist potential picks, then carry out more in-depth analysis on each potential purchase to determine its opportunities and risks going forward. This is the most work-intensive means of adding securities to your portfolio, and requires you to regularly monitor price changes in your holdings and stay current on company and industry news.
- Bond Picking — When choosing bonds, there are several factors to consider including the coupon, maturity, the bond type, and the credit rating, as well as the general interest-rate environment.
- Mutual Funds — Mutual funds are available for a wide range of asset classes and allow you to hold stocks and bonds that are professionally researched and picked by fund managers. Of course, fund managers charge a fee for their services, which will detract from your returns. Index funds present another choice; they tend to have lower fees because they mirror an established index and are thus passively managed.
- Exchange-Traded Funds (ETFs) — If you prefer not to invest with mutual funds, ETFs can be a viable alternative. ETFs are essentially mutual funds that trade like stocks. They’re similar to mutual funds in that they represent a large basket of stocks, usually grouped by sector, capitalization, country, and the like. But they differ in that they’re not actively managed, but instead track a chosen index or another basket of stocks. Because they’re passively managed, ETFs offer cost savings over mutual funds while providing diversification. ETFs also cover a wide range of asset classes and can be useful for rounding out your portfolio.
Step 3: Reassessing Portfolio Weightings
Once you have an established portfolio, you need to analyze and rebalance it periodically, because changes in price movements may cause your initial weightings to change. To assess your portfolio’s actual asset allocation, quantitatively categorize the investments and determine their values’ proportion to the whole.
The other factors that are likely to alter over time are your current financial situation, future needs, and risk tolerance. If these things change, you may need to adjust your portfolio accordingly. If your risk tolerance has dropped, you may need to reduce the number of equities held. Or perhaps you’re now ready to take on greater risk and your asset allocation requires that a small proportion of your assets be held in more volatile small-cap stocks.
To rebalance, determine which of your positions are overweighted and underweighted. For example, say you are holding 30% of your current assets in small-cap equities, while your asset allocation suggests you should only have 15% of your assets in that class. Rebalancing involves determining how much of this position you need to reduce and allocate to other classes.
Step 4: Rebalancing Strategically
Once you have determined which securities you need to reduce and by how much, decide which underweighted securities you will buy with the proceeds from selling the overweighted securities. To choose your securities, use the approaches discussed in Step 2.
Important: When rebalancing and readjusting your portfolio, take a moment to consider the tax implications of selling assets at this particular time.
Perhaps your investment in growth stocks has appreciated strongly over the past year, but if you were to sell all of your equity positions to rebalance your portfolio, you may incur significant capital gains taxes. In this case, it might be more beneficial to simply not contribute any new funds to that asset class in the future while continuing to contribute to other asset classes. This will reduce your growth stocks’ weighting in your portfolio over time without incurring capital gains taxes.
At the same time, always consider the outlook of your securities. If you suspect that those same overweighted growth stocks are ominously ready to fall, you may want to sell in spite of the tax implications. Analyst opinions and research reports can be useful tools to help gauge the outlook for your holdings. And tax-loss selling is a strategy you can apply to reduce tax implications.
The Bottom Line
Throughout the entire portfolio construction process, it is vital that you remember to maintain your diversification above all else. It is not enough simply to own securities from each asset class; you must also diversify within each class. Ensure that your holdings within a given asset class are spread across an array of subclasses and industry sectors.
As we mentioned, investors can achieve excellent diversification by using mutual funds and ETFs. These investment vehicles allow individual investors with relatively small amounts of money to obtain the economies of scale that large fund managers and institutional investors enjoy.
Source:
https://www.investopedia.com/financial-advisor/steps-building-profitable-portfolio/
ARTICLE # 2
Investment Portfolio: What It Is and How to Build a Good One (From NerdWallet.com)
Investment portfolios don’t have to be complicated. You can use funds or even a robo-advisor to build a simple and effective portfolio.
By Alana Benson and Anna-Louise Jackson, August 17, 2022
Like any industry, investing has its own language. And one term people often use is “investment portfolio,” which refers to all of your invested assets.
Building an investment portfolio might seem intimidating, but there are steps you can take to make the process painless. No matter how engaged you want to be with your investment portfolio, there’s an option for you.
Investment portfolio definition
An investment portfolio is a collection of assets and can include investments like stocks, bonds, mutual funds and exchange-traded funds. An investment portfolio is more of a concept than a physical space, especially in the age of digital investing, but it can be helpful to think of all your assets under one metaphorical roof.
For example, if you have a 401(k), an individual retirement account and a taxable brokerage account, you should look at those accounts collectively when deciding how to invest them.
If you’re interested in being completely hands-off with your portfolio management, you can outsource the task to a robo-advisor or financial advisor who will manage your assets for you.
Investment portfolios and risk tolerance
One of the most important things to consider when creating a portfolio is your personal risk tolerance. Your risk tolerance is your ability to accept investment losses in exchange for the possibility of earning higher investment returns.
Your risk tolerance is tied not only to how much time you have before your financial goal such as retirement, but also to how you mentally handle watching the market rise and fall. If your goal is many years away, you have more time to ride out those highs and lows, which will let you take advantage of the market’s general upward progression. Use our calculator below to help determine your risk tolerance before you start building your investment portfolio.
How to build an investment portfolio
1. Decide how much help you want
If building an investment portfolio from scratch sounds like a chore, you can still invest and manage your money without taking the DIY route. Robo-advisors are an inexpensive alternative. They take your risk tolerance and overall goals into account and build and manage an investment portfolio for you.
If you want more than just investment management, an online financial planning service or a financial advisor can help you build your portfolio and map out a comprehensive financial plan.
2. Choose an account that works toward your goals
To build an investment portfolio, you’ll need an investment account.
There are several different types of investment accounts. Some, like IRAs, are meant for retirement and offer tax advantages for the money you invest. Regular taxable brokerage accounts are better for nonretirement goals, like a down payment on a house. If you need money you’re planning on investing within the next five years, it may be better suited to a high-yield savings account. Consider what exactly it is you’re investing for before you choose an account. You can open an IRA or brokerage account at an online broker — you can see some of our top picks for IRAs.
3. Choose your investments based on your risk tolerance
After opening an investment account, you’ll need to fill your portfolio with the actual assets you want to invest in. Here are some common types of investments.
Stocks
Stocks are a tiny slice of ownership in a company. Investors buy stocks that they believe will go up in value over time. The risk, of course, is that the stock might not go up at all, or that it might even lose value. To help mitigate that risk, many investors invest in stocks through funds — such as index funds, mutual funds or ETFs — that hold a collection of stocks from a wide variety of companies. If you do opt for individual stocks, it’s usually wise to allocate only 5% to 10% of your portfolio to them. Learn about how to buy stocks.
Bonds
Bonds are loans to companies or governments that get paid back over time with interest. Bonds are considered to be safer investments than stocks, but they generally have lower returns. Since you know how much you’ll receive in interest when you invest in bonds, they’re referred to as fixed-income investments. This fixed rate of return for bonds can balance out the riskier investments, such as stocks, within an investor’s portfolio. Learn how to invest in bonds.
Mutual funds
There are a few different kinds of mutual funds you can invest in, but their general advantage over buying individual stocks is that they allow you to add instant diversification to your portfolio. Mutual funds allow you to invest in a basket of securities, made up of investments such as stocks or bonds, all at once. Mutual funds do have some degree of risk, but they are generally less risky than individual stocks. Some mutual funds are actively managed, but those tend to have higher fees and they don’t often deliver better returns than passively managed funds, which are commonly known as index funds.
Index funds and ETFs try to match the performance of a certain market index, such as the S&P 500. Because they don’t require a fund manager to actively choose the fund’s investments, these vehicles tend to have lower fees than actively managed funds. The main difference between ETFs and index funds is that ETFs can be actively traded on an exchange throughout the trading day like individual stocks, while index funds can only be bought and sold for the price set at the end of the trading day.
If you want your investments to make a difference outside your investment portfolio as well, you can consider impact investing. Impact investing is an investment style where you choose investments based on your values. For example, some environmental funds only include companies with low carbon emissions. Others include companies with more women in leadership positions.
While you may think of other things as investments (your home, cars or art, for example), those typically aren’t considered part of an investment portfolio.
4. Determine the best asset allocation for you
So you know you want to invest in mostly funds, some bonds and a few individual stocks, but how do you decide exactly how much of each asset class you need? The way you split up your portfolio among different types of assets is called your asset allocation, and it’s highly dependent on your risk tolerance.
You may have heard recommendations about how much money to allocate to stocks versus bonds. Commonly cited rules of thumb suggest subtracting your age from 100 or 110 to determine what portion of your portfolio should be dedicated to stock investments. For example, if you’re 30, these rules suggest 70% to 80% of your portfolio allocated to stocks, leaving 20% to 30% of your portfolio for bond investments. In your 60s, that mix shifts to 50% to 60% allocated to stocks and 40% to 50% allocated to bonds.
When you’re creating a portfolio from scratch, it can be helpful to look at model portfolios to give you a framework for how you might want to allocate your own assets. Take a look at the examples below to get a sense of how aggressive, moderate and conservative portfolios can be constructed.
A model portfolio doesn’t necessarily make it the right portfolio for you. Carefully consider your risk tolerance when deciding on how you want to allocate your assets.
5. Rebalance your investment portfolio as needed
Over time, your chosen asset allocation may get out of whack. If one of your stocks rises in value, it may disrupt the proportions of your portfolio. Rebalancing is how you restore your investment portfolio to its original makeup. (If you’re using a robo-advisor you probably won’t need to worry about this, as the advisor will likely automatically rebalance your portfolio as needed.) Some investments can even rebalance themselves, such as target-date funds, a type of mutual fund that automatically rebalances over time.
Some advisors recommend rebalancing at set intervals, such as every six or 12 months, or when the allocation of one of your asset classes (such as stocks) shifts by more than a predetermined percentage, such as 5%. For example, if you had an investment portfolio with 60% stocks and it increased to 65%, you may want to sell some of your stocks or invest in other asset classes until your stock allocation is back at 60%.
About the authors: Alana Benson is an investing writer who covers socially responsible and ESG investing, financial advice and beginner investing topics. Her work has appeared in The New York Times, The Washington Post, MSN, Yahoo Finance, MarketWatch and others.
Anna-Louise Jackson is a former investing and retirement writer for NerdWallet. Her work has been featured by Bloomberg, CNBC, The Associated Press and more.
» Curious about other types of investments? Learn about real estate investment trusts, futures, options and alternative investments.
» Read more: Simple portfolios to get you to your retirement goals
» Need help investing? Learn about robo-advisors
Sources:
https://www.nerdwallet.com/article/investing/investment-portfolio
