Introduction: Why Building an Investment Portfolio Is So Important?
The construction of an investment portfolio for oneself is one of the most significant financial decisions in your life. Of course, saving money in a bank deposit provides financial security and liquidity, but the opportunity for investments is a chance to grow money. You can see investing as planting trees. Saving will protect seeds, but investing will help them grow into a giant. The earlier you start, the longer your investments will have time to earn.
Recent investor behavior reveals the significance of the portfolio investing. The study showed that the balanced portfolio is still one of the most popular investing techniques for investors who continue to keep diversified portfolios including equities and fixed-income securities. Diversification remains one of the basic principles of efficient investing.
It is possible to say that building the first investment portfolio became much simpler thanks to low-cost index funds, ETFs and other innovations in modern finance which allow nearly everybody to start investing and creating their portfolio with small sums of money. Modern portfolio investing is much more accessible for investors than it was a decade ago.
The Difference Between Saving and Investing
There is a big difference between savings and investments as they serve different functions. Saving means safety and liquidity; investments imply making money grow. For example, if the inflation is equal to 3% per annum and the interest rate on your deposit is 1%, then the purchasing power of your money will fall slowly.
Investing means growing money in various asset classes such as equities, bonds, funds etc. As you can see, saving and investing are two different approaches. When people set certain financial goals for themselves such as saving for the retirement, purchasing the house, financial independence and so on, then they require not only protecting money, but also making it grow.
How People Build Their Wealth
The secret of successful investment is a compound growth. Compounding means earning returns on your earning. For instance, imagine that you invest $500 every month for some decades. It won’t grow linearly; on the contrary, you will earn returns on your returns and thus form a chain reaction.
Historical statistics prove the fact that long-term investors who stay in the market outperform those who buy and sell securities constantly. Several decades of research have shown that the S&P 500 provided good long-term annualized returns to people who stayed in the market all the time and didn’t try to time the market.
Your Financial Foundation Before Investing
You need to have a strong financial foundation before buying the first stocks and ETFs. Investing without financial stability is similar to building a house in the sand. Market changes are always unpredictable and you don’t want to sell investments in the downturn period due to the financial difficulties.
Creating an Emergency Fund First
The first thing which investors usually do before creating an investment portfolio is to create an emergency fund. According to the vast majority of experts, it is recommended to have three to six months of expenses in easy-to-access cash accounts. This will provide your investments with protection from being liquidated in case of unexpected financial issues.
Moreover, having the emergency fund increases psychological stability of investors. Market downturns are easier to tolerate when you know that your immediate needs are fully covered. Often, investors get panic in the moments of market decline because of their inability to cover urgent expenses.
Debt Repayment
Expensive debt may spoil your investments. For example, you pay 20% on credit card interest and hope to earn 8%. In this situation, you will definitely lose money. That is why repaying high-interest debt often brings much more profit than making risky investments.
After the expensive debts are repaid and the emergency fund is created, you can safely make investments and develop your portfolio.
Setting Up Your Investment Goals
In order to construct a good investment portfolio, you have to clearly define your goals as every portfolio depends on them. The goal setting is especially important because your portfolio has to reflect your purposes.
Short-Term Goals
Short-term goals include your financial needs in the period from one to five years ahead. These needs can be connected with buying a car, a trip, a marriage or a house down payment and so on. Thus, short-term portfolios usually have to be rather stable and conservative.
The investments for short-term goals include large shares of cash equivalents, short-term bonds and/or conservative funds. Stability matters more than the returns at these goals.
Long-Term Wealth Creation
When you talk about the retirement or financial independence, you are able to take more risks as you have more time for recovery. This is another reason why stock-heavy portfolios often outperform conservative portfolios.
The difference in the number of years which you have is the main reason why stocks provide better long-term returns.
Understanding the Level of Risk Tolerance
Risk tolerance is a very important concept in investing as it includes the level of risk that the investor can accept. Two investors can have the same income, but completely different tolerance towards risk.
Conservative Investors
Conservative investors are focused on preservation of money. They prefer stability, stable returns and low risk. Conservative portfolios usually contain high percentages of bonds, cash equivalents, and defensive stocks.
If you construct a portfolio for conservative investors, you should know that such portfolio will have smaller losses in the periods of market downturns, but it will have smaller long-term gains as well.
Moderate and Aggressive Investors
Moderate investors balance the growth and stability. Aggressive investors are interested in long-term growth and can accept significant losses during short periods. Young investors often have more aggressive allocations as they have much more time to recover from any losses.
Simple rules of the asset allocation remain quite popular with the beginners. The rule of thumb says that the percentage of stocks in the portfolio equals 100 minus investor’s age.
Modern version of the same rule includes subtraction of the age from 110 or 120.
Basic Building Blocks of an Investment Portfolio
There are a few asset classes which you have to learn when constructing your first portfolio.
Stocks
Stocks are the assets that give you the ownership of company’s part. Stocks usually bring you the biggest long-term growth and the largest risk as well. Stocks can bring you great profits, but can also bring company-related risks.
If you are a beginner investor, then it is better to purchase broad-market index funds rather than choose the individual stocks.
Bonds
Bond is a loan which you give to the government or to the corporation. Bond provides you with stable income from the coupon payments. Bond gives you stable returns, but lower compared to stocks.
Thus, bond is used as a tool for diversifying the portfolio and reducing the risk.
ETFs and Index Funds
ETFs and index funds have changed the whole investment landscape. Using index funds and ETFs, you can invest in thousands of stocks and bonds using only one purchase.
Recent studies of portfolio show that ETFs still dominate in investor portfolios thanks to diversification, transparency and low cost. The percentage of analyzed portfolios including ETFs reached 64%.
Alternative Assets
Alternative assets can be defined as gold, real estate, commodities and others. These assets are helpful in diversifying the portfolio due to the fact that alternative assets usually have other dynamics comparing to stocks and bonds.
Most investors include the alternative assets in modest percentages in order to have a well-diversified portfolio.
How to Allocate Your Assets
Asset allocation is the division of assets among the asset classes. Various researches confirm the fact that asset allocation is one of the main determinants of your portfolio performance.
Example of Portfolio Allocations Based on Investor Types
Investor Type Stocks Bonds Alternatives
Conservative 40% 50% 10%
Moderate 60% 30% 10%
Aggressive 80% 15% 5%
The above table includes only the examples. The final allocation depends on your goals, risk tolerance and timeline.
Age-Based Rule of Allocation
It is possible to apply the age-based rule when creating the first portfolio. The younger you are, the more stocks you are able to allocate in your portfolio due to the bigger investment time horizon. The older you are, the more bonds you can add to your portfolio.
The key here is to create an allocation that will suit you in any market environment.
Diversification
Diversification is often called a free lunch in the world of investments as this technique decreases your risk, but does not decrease your returns.
Diversification Among Asset Classes
Good diversification means the distribution of investments between asset classes, industries, countries and companies. Diversification allows investors not to depend on the particular companies or industries.
Surveys of investors show increasing popularity of diversified investing strategy compared to speculative investment in single assets.
Diversification Over Time
Diversification means not only diversification by the asset class. Diversification means also the diversification through time. For instance, regular investments mean the purchase of stocks at various levels of the market.
Investment studies show that consistent investing is usually better than timing the market.
Creating Your First Portfolio Step by Step
Creation of your portfolio can be a very simple task if you approach it in a right way.
Selecting Investment Accounts
First, you have to select a proper investment account where you will store your funds. Depending on the country, you can find various investment accounts such as retirement accounts, brokerage account or tax advantaged investment accounts.
You have to find an account that offers you low fees, good selection of assets and convenient interface. Fees are very important as every dollar spent on fees reduces your returns.
Choosing Investments
Beginners can choose the following investments:
Broad U.S. or domestic stocks index fund.
International stock index fund.
Bond fund.
Optional allocation of gold and real estate.
The great number of investors create the whole portfolio using several low-cost index funds. Studies show the increasing popularity of the passive investments among retail investors due to the fact that they are very diversified and very simple.
Automation of Contribution
It is very important to automate contribution to your investment account as it will remove emotions from the process. Automating means the schedule contributions no matter of the market situation.
It is possible to say that the regular automated investment is the diversification of the time.
Common Beginner Mistakes
New investors usually make the common mistakes that can lead to losing a lot of time. It is important to know these mistakes in order not to repeat them.
The first common mistake is investing in those stocks that brought great profits for someone else in the past year. Another mistake is making frequent trades which increases fees and can cause the emotional decision making.
Lack of diversification is also a very bad mistake as it means the concentration of investments in a couple of stocks or one industry. The emotional reaction to market downturns can be destructive for your portfolio. Surveys show that most successful investors do not change their strategies during the periods of market decline.
Other mistakes are ignoring fees, taxes and asset allocation. Every mistake can become costly during many years.
Monitoring and Rebalancing
Building a portfolio is only the first step. The further steps include monitoring and rebalancing.
When the market changes occur, your allocations automatically change and become unbalanced. For instance, the portfolio with 60% of stocks and 40% of bonds will become 75% of stocks after a great bull market. Rebalancing will restore the target allocations by selling the excess stocks and buying additional bonds.
Rebalancing usually occurs every year or in case when allocations are far from the target ones. It is possible to say that rebalancing encourages the discipline and systematic buying low and selling high.
Monitoring should be concentrated not on day-to-day changes in your portfolio, but on the movement towards your goals. Excessive checking can lead to the wrong decision making.
Conclusion
Building your first portfolio is more about the creation of the system than about the choice of perfect investment. It is important to have a good financial foundation, set up the goals, understand the risk tolerance and embrace diversification. Use low-cost funds, automate your contributions and stay invested no matter of the market conditions.