How To Build Your Portfolio
Becoming an investor is like starting your own business that has no employees but it creates financial freedom on it’s own. This is why it’s important to start investing as soon as you can.
Before you start investing you are going to need a roadmap and set-up goals for what you want to get from investing. A younger person just starting to work is going to have different goals than a 55 year old who is just getting ready for retirement. You are going to want to create your portfolio around those investing goals. If you are younger, you are going to want to set up your 401K or IRA with a more aggressive growth strategy because you will not be dependent on this money until you retire. Once you have decided your investing goals you can start setting up your portfolio using the following four steps.
Once you have your goals set up you need to decide what type of investor you are. You can either be active by managing your own portfolio or passive by getting a mutual fund or ETF. How you select your investments is determined by your risk tolerance. There is the risk return trade off which is the concept that the greater the risk the greater the reward. This also includes the opposite as well, the greater the risk the greater the losses. Your risk tolerance depends on the type of person you are.
If you are someone who gets worried at night about money and the nest egg you worked so hard to build up then you have a low tolerance for risk. The stress of worrying about money and how the market is performing isn’t worth the trade-off of better returns. A good night sleep will always help you earn more money and keep you healthy the next day. The general rule of thumb is as you get older and have a bigger nest egg, the lower the risk you should take on.
A conservative portfolio is designed to preserve your wealth or income. Conservative portfolios are comprised mostly of bonds, some stocks, and some cash and Credit Deposits or CDs. A sample allocation might be 70-75% fixed income securities (bonds), 15-20% equities (stocks), then 5-10% in cash and cash equivalents.
Generally speaking the more risk you can bear the more aggressive your portfolio will be. The following is a sample of a moderately aggressive portfolio which would be 50-55% equities, 35-40% fixed income securities, and 5 to 10% cash and equivalents. This portfolio is designed to achieve a balance of growth and income.
Above are just general rules of thumbs for the two types of portfolios. I’ve seen financial advisors recommend 70% stocks and 30% bonds for growth. If you are an active investor, managing your risk on a daily basis you might be 100% stocks. Bonds are seen as safe and stocks are seen as risky because stocks are 3x more volatile than bonds. If you are 60% allocated to stocks your returns can be 3x greater or 3x worse than just owning bonds. This is why it is important to understand your risk tolerance.
Once you have decided your allocation all you have to do now is invest. It can get complicated but the general rule is stocks are equities and bonds are fixed income. Now there are a lot of types of each.
Stocks-when purchasing stocks for your portfolio you want to consider sector (oil, transportation, banking, etc.), market cap (large companies or small companies), and stock type. You can use a stock screener that is usually provided free by a brokerage like Etrade to screen for the best stocks. You will then have to list the stocks you like and conduct more research. This is the most work intensive way to manage your portfolio because you want to make the right choices and then you have to monitor your stock prices. This is a very hands on approach.
Bonds-when selecting a bond you want to consider coupon (a payment made to you every six months usually), maturity (how long the bond is until expiration and you get your initial investment back), and the rating. Ratings start with AAA being the safest investment and go all the way down to junk status also known as grade C. The more As you have in the rating the safer the bond is for investing. The general rule is the US Treasury is a very safe investment.
Mutual Funds- are professionally researched and managed funds. An expert will pick stocks and bonds for you in a portfolio and charge you a fee for this type of investment. Those fees can add up so always research the fee before investing in a mutual fund.
Exchange Traded Funds (ETFs) – These are like mutual funds except without the high fee. ETFs trade like stocks because they are listed on the stock markets so they are riskier than bonds because they can be more volatile. ETFs are usually grouped by sector, capitalization, county, or pretty much anything. You can find and ETF that is triple leverage to the S&P 500 what that means is it is 3x more volatile than the S&P 500.
Periodically you will have to rebalance your portfolio. What this means is that through the normal trading day the value of your investments will change. You might start off 60% stocks and 40% bonds but the Dow Jones went on a run and now you are 68% stocks and 32% bonds. What this means is that you have to sell off some of the positions you gained on and allocate that to more bonds.
Another factor to consider is that your risk tolerance might change. Maybe you want to take on more risk so you would allocate more money to European stocks instead of American companies because the European market has started to recover. It’s all about balancing your portfolio weighting with your risk tolerance and investing strategy. Rebalancing is all about determining how much of one position you need to reduce/increase and allocate to other classes.
When rebalancing a portfolio you will ultimately be selling some securities and taking some gains so that you can reallocate that money to other investments. Anytime you sell anything you want to consider the tax implications. Selling a stock might get you a capital gains tax. So instead of selling you could just stop investing in that asset class. If you had a large stock gain increase, you can use dividends and other income to just buy bonds to rebalance your portfolio.
Do some research before you make any portfolio movements. If you think a stock in your portfolio will go down it’s ok to take the capital gains pay the tax and run. After all earning any money is a good thing even you might owe Uncle Sam a few bucks.
A well diversified portfolio is your best friend for growing your investments long term. Diversification protects you from changes in the economy over time. Always consider where you have the most risk and whether the offsetting potential return is acceptable
About Shaun Archer Tatum Shaun works in corporate finance in New York City. He has done financial consulting for several start-ups and has worked at several Fortune 500 companies. He has contributed several finance/investing articles on Seeking Alpha which have been published on Yahoo! Finance.