The most important aspect of building an investment portfolio is to balance growth opportunities with risks. Here are some essential steps for taking such an approach.
You don't need to be wealthy to succeed at portfolio investment. But, for your investment portfolio's returns to match or even outperform the broader stock market, you need some basic knowledge about how to invest. Investors can construct portfolios aligned with investment strategies by following a systematic approach.
Investment Portfolio - Key Takeaways
Investment portfolio definition
An investment portfolio is a group of financial assets owned by an investor with the expectation that it will earn a return or grow in value over time or both. A portfolio investment differs from an investment in a business you directly operate in that your stake is passive, meaning you don't make management decisions.
Portfolio investment may be divided into two main categories:
- Strategic investment involves buying financial assets for their long-term growth potential or their income yield, or both, with the intention of holding onto those assets for a long time.
- The tactical approach requires active buying and selling activity in hopes of achieving short-term gains.
Investment portfolios and asset allocation
The first step is to decide the level of risk you're comfortable with. Higher-risk investments can generate high rewards, but they also can result in large losses. Generally, investing in stocks produces the highest returns, while investing in bonds increases the stability of the value of your portfolio.
There are three key aspects that you must consider for asset allocation – your financial goals, investment horizon, and risk tolerance.
Before you commence building your portfolio, take stock of your short, mid and long-term financial goals. Short-term goals are meant to be achieved in less than three years, such as vacations or renovating your house. Mid-term goals can range from three-ten years and can include goals like paying for children’s college education. Long-term goals, such as retirement planning or buying a house, can take more than 10 years to accomplish. Our asset allocation should, therefore, reflect these goals.
This refers to the time period for which you expect to hold an investment. The investment horizon of the various assets in your portfolio should be decided according to your financial goals. Your portfolio should include assets that mature in time for short-term, mid-term, and long-term goals.
Risk tolerance is the level of risk you can withstand, and depends on your income, expenditure, and willingness to take risks. It can differ from person to person and may also change over time. For instance, your risk tolerance may increase as your salary appreciates, and lessen with more dependents and expenses. Risk tolerance can also be impacted by age as people who are closer to retirement may be less willing to tolerate high risk.
Risk diversification is one of the cornerstones of smart investing. It is based on the principle that different assets are associated with different levels of risk and involves investing across a variety of assets to minimize the impact of risks associated with any single asset class. Low-risk investments are typically associated with low returns, while high-risk investments often generate higher returns.
By investing across different asset classes, we can strike a balance between our risk and security. Diversification must also extend within each asset class. Investing across different industries and markets insulates your portfolio from a sudden downturn in these areas by limiting the damage. Risk diversification dictates that the risks of investing in high-growth stocks for optimum returns must be counterbalanced by low-risk, low-return assets such as market securities or bonds.
How to build an investment portfolio
Smart investing considers your current expenses while ensuring that you can plan for your short-term and long-term goals. The most important aspect of building a portfolio is to balance growth opportunities with risks. The trick lies in understanding your own risk appetite while building a diversified portfolio.
- Choose an account that works toward your goals.
- Choose your investments based on your risk tolerance.
- Determine the best asset allocation for you.
- Rebalance your investment portfolio as needed.
1. Choose an account that works toward your goals
To build an investment portfolio, you’ll need an investment account with a brokerage like CAPEX.com. Different stockbrokers provide different types of accounts, commissions plan, and ranges of markets.
Investing accounts are most suitable for the traditional ‘buy and hold’ strategy, in which an individual will buy an asset outright with the intention of holding it for a long period of time and selling it for a profit later.
They are different from trading accounts, which are used for speculating on the future price of a market via derivative products. These products take their value from an underlying asset, and do not require a trader to own the asset in order to take a position.
Traders can not only open the more traditional ‘long’ position, but they can take advantage of markets that are falling in price too – known as going ‘short’. This opens a whole other avenue of potential profit.
Consider what exactly it is you're investing for before you choose an account. Please, note that CAPEX.com offers both possibilities, with us you can buy traditional shares and funds and trade on shares, indices, bonds, commodities, forex, and cryptocurrencies.
2. 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:
Bonds are loans to companies or governments that get paid back over time with interest. Bonds are 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.
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 green energy companies, gold mining stocks, and electric vehicles.
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.
3. Determine the best asset allocation for you
So, you know you want to invest in funds mostly, 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.
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. Look at the examples below to get a sense of how aggressive, moderate, and conservative portfolios can be constructed.
This portfolio invests in fixed-income products and is designed for investors who are either very risk-averse or have short time horizons. Exposures will be primarily to government and corporate bonds, with additional exposure to high-yield, index-linked and emerging-market bonds. Returns will mainly be achieved by reinvesting income, and there is very little scope for capital growth.
This portfolio primarily invests in fixed-income products such as government, corporate and high-yield bonds, but also has some exposure to dividend stocks and value stocks, and alternative assets such as gold. It’s designed for investors that are looking to protect their savings, but still want to keep ahead of inflation in the long run.
This portfolio invests in a roughly equal blend of fixed-income products and global equities, with the addition of some alternative assets such as property and gold. It’s designed for investors that want to grow their savings over time but want to do so with the improved diversification that fixed-income products can provide. Returns from this portfolio will be achieved through a mixture of capital growth and reinvesting income.
This portfolio primarily invests in global equities, with additional diversifying exposures to fixed-income products and alternatives. It’s designed for investors with a high-risk tolerance, who are prepared to see sizeable fluctuations in the value of their investments in order to achieve long-term growth. Returns from this portfolio will mainly be achieved through capital growth, but also by reinvesting income.
This portfolio predominantly invests in growth stocks, with residual exposure to fixed-income products and alternatives. It’s designed for investors with a very high-risk tolerance or those with an extended time horizon who can afford significant fluctuations in their savings as they try to achieve higher long-term growth rates. Returns from this portfolio will mainly be achieved through capital growth, but also by reinvesting income.
4. Rebalance your investment portfolio as needed
Once you have an established portfolio, you need to analyse 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.
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.
Investment Portfolio Tips
At this stage, you should have a clearer picture of how you’ll manage your investment process. You know why you’re investing, how much money and time you can commit, as well as how much growth you want to achieve and in what timeframe.
Now you’ll need to introduce a little reality check. There are risks involved with investing money. You need to think carefully about everything that could derail your wealth-building and develop a plan for how you’ll deal with these situations should they arise.
Below are a few tips that will help you plan for almost any future risk.
1. Check the average returns of the market you plan to invest in
If you’ve never invested before, it’s impossible to guess how much you can expect to profit from a particular asset. Your strategy should therefore include the market’s average annual returns. Remember, this is just to give you an idea of past performance, but there’s no guarantee that these results will continue after you put your money up.
Knowing how much you can expect to gain each year will be useful in choosing investments that could help you reach your goal. It can also help you adjust your strategy if needed since you’ll be able to see if your goal is attainable in your preferred timeframe.
However, an asset or market that yields more returns may also be one that’s prone to higher levels of volatility and thus risk.
Remember, investing is a long-term endeavour, so making quick money shouldn’t be your goal here. Assets with a better track record of consistent returns should ideally make up most of your portfolio.
2. Consider how much you might lose
The main risk of investing is that the value of your investment could fall at a time when you need to access your cash. While it’s impossible to know how much you could lose on an investment, you can get a sense of this by looking at its history.
However, sometimes unprecedented events can cause a market that normally does well to experience a downturn, regardless of its past performance. For example, the US Tech 100 had hit a series of record highs before the spread of the novel coronavirus in 2019/2020.
When the pandemic hit globally, it brought about a huge drop in the index’s performance as lockdowns limited trade across many of its constituents.
The stock markets and major stock indices later recovered these losses. But had you invested in a Nasdaq 100-tracking ETF and sold your position before this, you would’ve made a significant loss.
3. Know the right action to take
Watching your investment drop in value could tempt you to sell your stake prematurely. It’s only by studying an asset’s patterns in the market that you can understand important details about its performance.
Just like a sale in a store, falling share prices may present an opportunity to buy. So instead of selling assets that could recover in the future, you can instead increase your holdings with the hope that the market will bounce back. Alternatively, you can hedge your portfolio with derivatives.
When you look at an asset’s history, consider factors like how much its value fell before it recovered in the past as well as the timeframe in which this occurred. Having those details close at hand when the markets drop will help you hold steady when the price drops again because you’ll understand that falling share prices are a normal part of investing.
The financial markets are volatile, however. So, there’s no guarantee that a particular asset will return to its previous levels as it did in the past.
4. Back your portfolio up with a stop-loss order
An investment portfolio is essentially meant for the long term. By allowing your investments to mature over a period, you can also let the associated risks play out. For long-term investors, a buy-hold strategy can be more beneficial than day trading and even swing trading which requires constant vigilance and comprehensive knowledge of the market.
At the same time, it is important to limit your losses through strategies like a stop-loss order. It is an order placed with a broker to buy or sell a security when it reaches a certain price.
For instance, if your stop-loss is set at 12%, the broker will sell the stock when it falls 12% below the price you paid for the stock, protecting you from any further losses.
5. Study the market, assess the qualitative risks of a stocks
To be a long-term investor, you must also invest some time in studying the markets and understanding the factors that influence their movements. The main markets include the money market, capital market, credit market, foreign exchange market, and debt market. FED and other central banks' policies, inflation, demand and supply are just some of the factors that impact market fluctuations.
In addition, you must also assess the risks associated with any stock before you invest in it. For qualitative risk analysis, you must consider the background of the company, including its corporate governance and compliance, competitive advantage, brand value, and the presence of risk management practices.
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 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.
Before you start building an investment portfolio, you should consider using the educational resources we offer, like CAPEX Academy or a demo account. CAPEX Academy has lots of investing courses for you to choose from, and they all tackle a different financial concept or process – like the basics of analyses – to help you to become a better trader or make more-informed investment decisions.
Our demo accounts are a suitable place for you to learn more about traditional shares dealing and leveraged trading, and you’ll be able to get an intimate understanding of how leverage works – as well as what it’s like to trade with leverage – before risking real capital.