Investment portfolio. Why it is necessary. And how to form it. Step by step

 

Step 1: Analyze your goals and constraints

An investor should clearly understand his or her expectations and opportunities. This can be as much about capital appreciation as it is about capital preservation. Even an extremely ambitious goal should be realistic. It should also be realized that usually the greater the risk, the higher the return.

What factors to look for when building a portfolio:

• Time horizon. This is the key parameter that an investor must decide on. The longer the horizon, the higher the return on investment over time – the effect of compound interest will work. That is, every year the amount accumulated with the interest rate is added to the investment. However, if you enter the market for a short period of time, your risks increase due to high volatility and possible unsuccessful entry points.

• Liquidity is the ability to sell securities quickly and profitably at a price that will be close to market value. Your portfolio should always contain liquid assets that can be realized in an unforeseen situation to generate income. It is up to you to decide how many of them you should have.

• Unique factors. If you have beliefs that certain businesses should not be invested in, or you are willing to make money on tobacco companies, for example – this will affect the composition of your portfolio.

Step 2: Selecting the right tools

An investment portfolio is a set of stocks, bonds, mutual funds and index exchange-traded funds (ETFs), deposits, currencies, precious metals and other financial instruments. They differ not only in their fundamental characteristics but also in their degree of risk. As a rule, the higher the yield of an instrument, the greater the risks associated with it. The least risky instruments are those that are close to “cash” (short-term government bonds), while the most risky are shares of young companies and futures.

A beginner should listen to the advice of professional analysts, as well as study the basics of investing on his own. In any case, if you want to start building your own portfolio, remember a few basic points:

• you should start by investing in the types of businesses and tools you understand best.

• if you want to invest in a particular industry, focus on its leaders

• when investing in outsiders, it is worth understanding the reasons for their decline and assessing future catalysts for growth

• give preference to liquid instruments – those that you can sell profitably at any time

• do not add risky financial instruments (options, deposits, futures) to your portfolio if you are not fully confident in your investment skills

Step 3. Allocation of investments within the portfolio

Passive and active investments

There are three main approaches in investing: passive, active, and combined.

Active investing involves greater time commitment and higher returns compared to passive strategies, while passive investing offers market following with more infrequent rebalancing.

You can learn more about active and passive investing in our material «Passive Investing. How to earn money for long-term goals».

Diversification vs concentration

Diversification implies the possibility of risk management. Two approaches are possible:

• Narrow – allocation of funds among assets from one product group, one market or industry.

• Broad – distribution among different asset classes from different markets or countries.

Ideally, the assets in a portfolio should be weakly or negatively correlated with each other. That is, all securities should not be from the same industry, as they will behave the same way – rise or fall together. To prevent this from happening, broad diversification is optimal.

When building a portfolio, it makes sense to limit yourself to about 5-15 companies from different sectors. The easiest way is to divide the investments into equal parts.

A more common proven approach is to place most of your available assets in liquid companies and invest the small balance in high-risk stocks. This way you can be sure of the stability of your portfolio, even if trading with risky financial instruments does not go according to plan. And by diluting the portfolio with bonds and foreign securities, you can get a fairly balanced set.

According to the level of risk, there are three main types of portfolios

Conservative — the least risky. It consists mainly of shares of large, well-known companies (blue chips), often rich in dividends, as well as bonds with high ratings. The composition of the portfolio remains stable over a long period of time and is less likely to be revised. This type of portfolio is primarily aimed at preserving capital, which does not exclude receiving moderate income from the growth of quotations, dividend flow and bond coupons.

Aggressive — includes shares of rapidly growing companies, speculative bonds, futures. Leveraged trading is possible. Investments in the portfolio are quite risky, but at the same time can bring the highest income.

Moderate — combines the qualities of aggressive and conservative portfolios. It includes both reliable securities purchased for a long period of time and risky instruments, the composition of which is periodically updated. Capital growth is average, and the degree of risk is moderate. This type of portfolio is the most balanced.

Step 4: Performance evaluation and portfolio rebalancing

You should periodically evaluate the portfolio performance: once in a certain period of time (a day, a month, a quarter…) monitor which assets are growing and which are falling.

How to do rebalancing:

• Watch how the stocks you buy behave and don’t miss corporate events if possible.

• Determine the stop-loss level in advance — how much the security you bought can “fall” while remaining in your portfolio. As soon as prices fall below the level acceptable to you, immediately get rid of the unprofitable asset. Hedging, i.e. opening opposite positions, is also possible — read more about it here. Such a strategy will allow you to insure yourself against possible losses, avoiding too active actions with the underlying instruments.

• If you are investing for the long term, you need to review how the shares in your portfolio are changing. For example, you invested 50% of your money in stocks and another 50% in bonds. Then the stocks went down and the bonds went up in price. Accordingly, to bring your assets back to their original allocation of shares, you need to buy back stocks. If stocks then rise significantly, it makes sense to sell them and move some of your money to a safer haven — primarily bonds.