A well-put-together portfolio is crucial to the success of an investor in the financial marketplace nowadays. For individual investors, you will need to understand how to decide on a suitable asset allocation for your risk tolerance and investment goals. Put simply, your portfolio needs to meet your future capital requirements and give you confidence in the process.
Above all else, diversification is key. Stock investors are always hearing about the wisdom of diversification. That being the enduring moral of not putting all of your eggs into one basket. Generally speaking, diversification helps in reducing risk and usually results in a much better return on investment.
With all of this in mind, there are plenty of factors concerning portfolios that one should keep in mind. This article will explore what every investor needs to know.
What is a portfolio in the context of investments?
A portfolio is a collection of various financial investments. The most common types are bonds, stocks, cash, commodities, and cash equivalents (ex. closed-end funds and exchange-traded funds [ETFs]). It also refers to investments that an investor will use to generate a profit. At the same time, they are ensuring that capital or assets are undergoing proper preservation. For the most part, people believe that cash, stocks, and bonds make up the core of a portfolio. While sometimes true, it is not the norm, nor is it a rule. Portfolios might contain various types of assets, some of which include real estate, private investments, and even art.
You may decide to hold and take over portfolio management yourself. Alternatively, you may leave the job to a financial advisor, money manager, or another type of finance professional.
As stated before, a key concept in portfolio management is diversification. Diversification sets out to scale down risk by dividing investments among an array of financial instruments, industries, and other categories. It intends to maximize returns by investing in various areas that would each have a different reaction to the same event. There are plenty of ways to diversify; however you do it is up to you. Factors that properly build your portfolio are your personality, your future goals, and how much risk you can handle.
Investment portfolios come across as a pie that has been cut into pieces of varying sizes. Each slice represents a distinct asset class and/or investment type. Investors hope to create a diverse portfolio so that they can reach a risk-return portfolio allocation that suits their risk tolerance. Stocks, bonds, and cash are, for the most part, seen as a portfolio’s primary building blocks. However, it is possible to develop a portfolio with several types of assets. Some of which include gold stocks, real estate, various bond types, and even paintings and other art collectibles.
The assets inside a portfolio are known as ‘asset classes’. The investor or financial advisor has to ensure a solid mixture of assets in order to preserve balance. Doing so will help promote capital growth with control – and a limit – on the risk. A portfolio will usually contain the following:
- Stocks: When it comes to investment portfolios, stocks are by far the most common component. They primarily relate to a share or portion of a company. This means that the stocks’ owner is also a co-owner of the company. The ownership stake’s size largely depends on the total number of shares he or she owns. Stocks function as a source of income because when a company generates profits, it shares some of them through dividends to its stockholders. Moreover, because shares are buyable, it is possible to sell them at a higher price. This, however, depends on the company’s overall performance.
- Bonds: When an investor purchases bonds, they are loaning money to the issuer of the bond. Examples of this include the company, the government, or an agency. A bond has a maturity date, meaning that the date that the principal amount puts towards buying the bond needs to return with interest. In comparison to stocks, bonds are not as risky, yet they offer lower rewards.
- Alternative investments: These investments can be good additions to an investment portfolio. They can usually be assets whose value grows and multiplies, like gold and oil, as well as real estate. Unlike traditional investments, such as bonds and stocks, alternative investments do not trade as often on a wider scale.
There are a wide variety of portfolio types, with each one being unique due to its investment strategies. Some of the most common types of portfolios include the three below.
- Growth portfolio: These portfolios intend to promote expansion by taking bigger risks, which includes investing in developing industries. Portfolios that concentrate on growth investments will usually offer higher potential rewards, as well as coinciding with higher potential risk. Growth investing typically involves investments in much younger companies that have more potential for development in comparison to larger firms.
- Income portfolio: Generally speaking, an income portfolio concentrates on procuring consistent income from investments rather than potential capital gains. A notable example of this is purchasing stocks depending on the stock’s dividends. This is instead of buying them based on a history of share price appreciation.
- Speculative portfolio: This portfolio type is the closest to gambling that you can get as it pertains to taking a lot of risks. Speculative plays can often include initial public offerings (IPOs) or stocks that are supposedly takeover targets. Healthcare or technology firms developing a breakthrough product often fall into this category.
- Value portfolio: These portfolios allow investors to take advantage of purchasing cheap assets by valuation. They are particularly helpful during difficult economic periods when investments and businesses try to stay afloat. Investors opt to look for companies that have serious profit potential, yet are priced below what is deemed their fair market value. Put simply, value investing puts all its focus on searching for market bargains.
How to build one
So, you wish to create a good investment portfolio. That’s great, but how do you go about doing that? Well, all investors or financial managers need to take four important steps.
- First and foremost, you need to determine the overall objective of the portfolio. Investors should ask themselves what their portfolio is going to be for. Doing so will establish the direction on what investments should be taken.
- Next, you will need to reduce investment turnover. Some investors prefer to regularly buy and sell stocks, all within a short period. What they must keep in mind is that this will increase the cost of transactions. Furthermore, some investments take a while before they pay off.
- It is important that you do not spend too much on a single asset. The higher the asset acquisition price means that the break-even point to meet will also be higher. Therefore, the lower the asset’s price, the higher the potential profits will be.
- The final step is just this: remember to never depend solely on a single investment. We are all familiar with the saying, “Don’t put all your eggs in one basket,” as mentioned earlier. In this context, what makes a successful portfolio is the diversification of investments. When certain investments are declining, others are probably rising. Sustaining a broad investment range helps lower any possible risks for an investor.