Building an Investment Portfolio
To the uninitiated, investing may seem like gambling. However, there is a great deal of science that goes into planning an optimal investment portfolio. Diversification should be your main focus when investing and should always be considered as the key to your long term success. Diversification should never be ignored and in economics, it is often said that there is no such thing as a free lunch, with the lone exception being diversification. Diversification is the technical term for the phrase “don’t put all of your eggs in one basket.” In this article, we will discuss some key points in how to build your investment portfolio with stocks and bonds that will help you earn decent returns without undue risk.
Stocks and Bonds
Historically, stocks have produced higher returns but at much greater risk than bonds. While bonds offer lower returns, they are also less likely to lose money in any given year. The lower risk of bonds results from the fact that they are debentures that carry a contractual obligation to pay, whereas stocks only pay off, after all company debt is paid. In a flight to safety or a risk-off event, investors sell stocks and buy bonds. Here is where diversification comes in. Since bonds typically perform well when stocks do poorly, by holding stocks in combination with bonds, we can lower risk without sacrificing much return. Investors can buy individual stocks and bonds, or they can use mutual funds and exchange-traded funds.
Individual securities offer a degree of precision, but transaction cost and level of diversification make funds more attractive for all but the wealthiest investors. The reason is that in order to achieve proper diversification, hundreds of stocks and bonds will need to be purchased and periodically re-balanced. Even at $10 a trade, this will result in higher transactions cost than the expense ratio on most funds.
Now that we have settled on using funds to build our portfolio, a common question relates to the appropriate number of funds. In this case, more is not necessarily better. In fact, you can build a diversified portfolio with as few as four funds. Holding more than 15 funds probably leads to unnecessary redundancy and higher fees. If you do hold as few as four funds, it is important to choose diversified funds that cover broad asset classes, such as U.S. stocks, bonds and international securities. You may also want to look into buying closed-end funds.
The next question to answer involves the right allocation to stocks and bonds. One long-standing rule of thumb suggests putting 60% of assets in stocks and 40% in bonds. Another rule calls for putting a percentage in bonds equal to your age. This implies that as we get older, we should reduce risk by placing more of our money in bonds. The rationale for this adjustment is that, as we get closer to retirement, we have less time to recover from a steep decline in stocks.
This brings up the concept of risk tolerance. A younger investor may be willing to take more risk than an older investor. Likewise, someone with a stable career and steady income may be willing to take more risk with their investment portfolio, as would a dual income family compared to a single earner. The more risk you can tolerate, the more stocks you will own. Speaking of risk tolerance you might consider investing in options and if you do so it is important understand the risk involved in doing so. Go slowly with options if you choose to go there at all.
As markets fluctuate, your portfolio may deviate from your target allocation. To keep your allocation in line with your target, you will need to rebalance periodically. At a minimum, you should evaluate your portfolio annually but no more than monthly. In fact, monthly rebalance is likely to cause higher transaction cost without incremental benefit. Even an annual rebalance may not trigger any trades, as long as your allocation is within plus or minus 5% of your target.
For those that don’t want to choose individual funds and make these allocation decisions, a simple alternative is a target date fund. Target date funds provide a diversified portfolio appropriate for your age and risk tolerance. They will also rebalance over time and adjust their stock/bond allocation in what is called a glide path.
Building an investment portfolio is an important part of retirement planning. The process
need not be overly complicated but there are a few key guidelines to remember:
- Contemplate risk tolerance
By diversifying your assets and allocating between stocks and bonds, you can reduce your risk and improve your chances of your investment portfolio being a success.