Three basic elements of an Investment Portfolio
Part II of AWM’s InvestHER series - (Also published on LinkedIn)
So you want to invest, but you're not sure where to start or if you're already on the right path. Pay attention to these three concepts when building an investment portfolio.
The steps below are very broad and general. While I've only outlined three main elements, a solid portfolio will really have hundreds, if not thousands, of considerations. That's why it's a good idea to involve a professional to help you. Using the Investment Policy Statement (IPS) you developed in Part I of the InvestHER series as your guide, you can begin to build a portfolio of investments.
First you'll evaluate your risk appetite set forth in your IPS and the risk of the investments that you are looking at. The idea with investing is to get a maximum amount of return for as little risk as possible. This goal is easier said than done. Typically, the greater the return in an investment, the greater the risk you are undertaking. Likewise, the less of a return in an investment, the less risk you are taking. There are ways to reduce or spread out the amount of risk you will take when investing in a portfolio, depending on the actual underlying investment. Some unsystematic risk can be diversified away, meaning the more securities you add to your portfolio, the more your risk will decrease. Some systematic risks cannot be diversified away but rather will need to be used strategically in your portfolio.
Types of risk you'll need to evaluate include, but are not limited to
Purchasing Power
Reinvestment Risk
Interest Rate
Market
Business
Default
Liquidity
Tax
Political
More!
Ask yourself, how much risk are you willing to take? And how risky is this investment that you're looking at?
2. Then we will look at your asset allocation. This term refers to the process by which you will be spreading out your investments over different asset types. About 92% of your long-term performance will be determined by your allocation, not market timing. You'll need to divide a percentage of your investment funds among the following classes:
Short term liquidity money market securities
Long term Fixed-income, like bonds and T-bills
US Equity stock
International stock
Real Estate
This mix of investments should be unique to you and your personal financial situation. The asset allocation is a long-term strategy used to meet your goals. As time progresses, your actual portfolio will look different from your original allocation, due to the performance of the underlying investments. You'll need to revisit the mix periodically to rebalance and get your portfolio back in line with your asset allocation or determine a new mix based on your current financial situation.
3. Now it's time to evaluate the individual investments. Using either fundamental and/or technical analysis, you'll need to develop a case for and against each asset. It's important to play devil's advocate here and find reasons not to invest. Much like a scientist with a hypothesis, a good investment manager will look for reasons not to invest in an asset. From each of the asset classes, you'll be able to decide what type of vehicle to put your investment in.
Fundamental analysis is the science of evaluating an asset to determine a fair market value.
Technical analysis then uses the fundamental data to look at trends and try to estimate future value.
Good portfolio managers will use a combination of the two types of analysis when evaluating companies.
These companies can then be purchased outright on the stock market, or you can invest in a pool of securities, such as an ETF or Mutual Fund. Each type of pool has it's own benefits, risks and fees, so be sure to know what you are getting into. Do a cost analysis to determine if it's right for you. You can also apply these concepts above to evaluate fixed income instruments, such as bonds, T-bills or even real estate.
The message I hope you take from this article is that building a portfolio takes time, patience and extensive research. An investment portfolio is not a "get rich quick" scheme, but rather part of a long-term strategy. A portfolio goes hand in hand with an Investment Policy Statement and should be appropriate for your unique situation. Every investHER should know her goals, her appetite risk, her experience as an investor and her total net worth to determine what she should invest in.
Next week we will talk about how, where and when to save money to invest. At Audax Wealth Management, we call this the "savings wheel".
Until next time, be well.
