It is important not just to have an investment portfolio but to have a well-maintained and profitable one. As an investor you need to learn what you can about asset allocation in order that you can choose the best investment strategies for you. To put it another way, your portfolio of investments should be able to adequately meet the future needs you have for capital as well as to help you to have the necessary peace of mind you seek. It is pertinent that as an investor you design your portfolio to be in line with your future goals and your investment strategies. To do this you need a systematic approach. Here we take a look at the steps required to do just that.
Step One- Asset Allocation
To begin you must take a close look at your own personal financial situation and determine what your investment goals are. You must take into consideration your age, how much money you have to invest, your future financial needs and how much time you have to build your investments. A 24 year old single individual fresh out of university will need to devise a very different investment strategy than will a 45 or 50 year old married individual trying to pay off a mortgage and getting ready to send a son or daughter off to college.
You also need to consider your risk tolerance as well as your personality. Are you a big risk taker or a little one? Are you willing to invest and take the risk knowing that you could lose but could also reap greater returns or does that make you shudder inwardly? Both of these items are connected and play a role in which type of investments you should select.
Once you are aware of your present situation as well as your future requirements for capital and your risk tolerance you will then be able to decide which asset classes you should allocate for your investments. Risk/return tradeoff is the name given to the principle of the possibility of greater returns at the expense that comes with the greater risk of losses. This is different for everyone.
Are You a Conservative or Aggressive Investor?
The more risk you are willing to bear in terms of your portfolio the more aggressive investor you are. If this describes you then you should concentrate more of your attention on equities and less on bonds and other types of fixed-income securities. On the other hand, the less risk you are willing to bear, the more conservative will your portfolio be. You must define yourself as an investor.
The primary goal of a portfolio that is conservative is to protect the value of it. An example of such a portfolio includes 70 to 75 percent fixed income securities, 15 to 20 percent equities and 5 to 15 percent cash and equivalents.
An aggressive or moderately aggressive portfolio is geared towards those who have an average risk tolerance. The goal of this type of portfolio is to strike a balance between income and capital growth. It might look something like this- 50 to 55 percent equities, 35 to 40 percent fixed income securities and 5 to 10 percent cash and equivalents.
Step Two- Achieving the Portfolio You Desire
After you do what is required in step one, which is to determine the proper asset allocation for your portfolio you then need to divide the capital you have amongst the asset classes you have chosen. On a very elementary level that means breaking down bonds into the bond class and equities into the equity class, etc.
You can also take it one step further and break down asset classes into subclasses that come with different types of risks and different potential returns. For instance you might take your equities and divide them between different sectors and market caps. You also might divide them between domestic stock and foreign stock.
There is more than one way to select the assets and securities that will satisfy the asset allocation strategy you have chosen. It is important that you analyze both the potential as well as the quality of every investment before you purchase it.
Stock picking is one option. You should select stocks that are in line with the amount of risk you are willing to take in the equity section of your investment portfolio. Consider such factors as stock type, market cap and sector. Make use of stock screeners to analyze companies and then create a shortlist of your top choices. If you go this route then you must regularly monitor the price changes that occur in your holdings as well as to keep up-to-date on the latest news in the industry.
Bond picking is another option. When selecting bonds consider such important things as the bond type, the bond rating, coupon, maturity and the general interest rate environment.
As far as mutual funds are concerned, be aware that they are available for a vast range of asset classes. Mutual funds make it possible for you as an investor to have both stocks as well as bonds that are well researched and chosen by professional fund managers.
If you do not wish to invest your money in mutual funds then exchange-traded funds (ETFs) are another alternative worth considering. ETFS are comparable to mutual funds that can be traded like stocks. They represent a large assortment of stocks that are generally grouped together by capitalizations, sector and country. However ETFs are not actively managed but what they do instead is they track a chosen index or other assortments of stocks. ETFs can cover a wide range of assortment classes and are an excellent means of rounding out a portfolio.
Step Three- Taking the Time to Reassess Portfolio Weightings
After your portfolio has been established it then becomes time to analyze and rebalance it on a periodic basis. You need to do this because movements in the market can sometimes cause the initial weightings you have to change. In order to assess the actual asset allocation of your portfolio you need to quantitively categorize all of your investments as well as to figure out the value proportions in relation to the whole.
Over time other things can change as well. Your financial situation can change as well as your future need for capital and your risk tolerance. These things can change at different times throughout an investor’s life. When any of these things become altered you need to adjust your portfolio to reflect these changes. For example, if your risk tolerance has gotten lower then you may have to reduce the number of equities you have.
To rebalance your portfolio you must figure out which of the positions you hold are overweighted and which are underweighted. To use an example, if 30 percent of your current assets are in small-cap equities and your asset allocation says that you should have approximately 15 percent of your assets in this class then you need to rebalance. When you rebalance you take a close look at your position and from there figure out what you need to reduce and what needs to be allocated to different classes.
Step Four- Doing a Strategic Rebalancing Act
By the time you reach this step you know which securities you require and which ones need to be reduced and by how much the reduction must be. You also know which securities are overweighted and underweighted.
When you decide to sell some of your assets in order to rebalance your portfolio consider the tax implications this brings with it. You also need to consider what the outlook of your investment securities are. If you have reason to believe that you have overweighted growth stocks that are about to drop then it might be in your best interests to sell some of them even if the tax implications say otherwise. To gauge the outlook it helps to look to research reports as well as listen to the opinions of financial analysts.
Investment Diversification Matters
Always bear in mind this rule of thumb for building a profitable portfolio- diversify as much as possible. If you don’t put all of your eggs in one basket then you are in a much stronger position investment wise. Always maintain diversification. Having securities from each asset class is important but it is not enough. Instead you must diversify within each asset class. Take the holdings you have in an asset class of your choice and spread them across a variety of subclasses as well as sectors of industries.
To achieve the diversification you need to be as profitable as possible and to see your money grow it is wise to use both mutual funds as well as exchange-traded fund (ETFs). These will make it possible for you as an individual and average investor to see the economies of scale that characterize large fund investors.