Build a portfolio for all seasons.
There are numerous factors to be considered when building an investment portfolio. However, the more effort you put into addressing them, the more likely you are to meet your investment goals.
What follows is my personal view, which won't necessarily accord with what everyone would agree is best practice. I'd certainly advise that newbies to investing read widely about this area, which is of fundamental importance.
Investment aims
The first thing to do is to fix your investment aims and the time period that you wish to stay invested. This will allow you to determine your asset allocation strategy. Other factors that will also have a bearing on this include:
- your personality and risk tolerance;
- your present financial situation; and
- your age and investment time horizon.
Certainly, if you have the opportunity, pay into your company pension scheme since you'll obtain tax relief by doing so. Secondly, don't invest money in stocks that you're going to need in the short term (within 2-5 years).
Diversification
Diversification is defined as the spreading of your portfolio across different asset classes, including equities, ETFs, bonds, property, alternatives and cash. This reduces the overall risk of your portfolio, compared with investing in just one asset class.
Of course, you need to be very careful in selecting any class of asset, as it doesn't necessarily follow that a given bond will automatically be safer than a particular share.
Some, such as the legendary investor Warren Buffett, have even argued that diversification is often an attempt to reduce risk by people who don't know what they are doing. I see the logic of his argument, which is that if you've really done your research you shouldn't need to diversify too greatly.
He may be right, theoretically, but in practice many investors are lesser mortals and are better off diversifying a little. Still, having five sound investments will always be better than having 50 unsound ones.
Asset allocation strategy
You'll hear lots of fancy names for asset allocation strategies you should adopt and it's best not to get too carried away with them. However, you need to consider:
- whether you need an income stream;
- the underlying liquidity risks of any investment (i.e. can you sell it when you need to)
- inflation risks; and
- your desired rate of return.
I myself have adopted a simple 'core-satellite' approach, with most of my portfolio in fairly low risk assets and a small proportion in riskier areas that I hope will deliver outstanding returns.
I personally wouldn't put more than 25% of my savings in equities at any one time. I'd also keep between 20% and 30% in cash. Equities can be volatile so that is why I prefer to drip feed money into them, while the cautious creature in me likes to have cash on hand for a rainy day or emergencies or simply to buy underpriced assets. The balance is in bonds of varying types, with a little in gold.
Correlation
I'd be the first to admit that probably my investment portfolio isn't well balanced and shows a worrying trend to mirror my own risk-taking nature.
One area that I know needs more attention is the correlation of the assets within my portfolio. There's no point diversifying if the price of all the assets you hold drops at the same time!
Performance
It is also useful to benchmark the performance of your investment portfolio. Most typically it is done against an all equity index -- as most aim for equity-like returns as a minimum. For example, many international fund managers use the Morgan Stanley Capital International (MSCI) World Index (a global benchmark).
More on investing basics:
