Beginners guide to investing part 8:How to construct an investment portfolio

“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.

— George Soros

INTRODUCTION

Welcome back.  If you are just joining the investing series, I do recommend that you start at part one. 

Every investor will get things wrong. Not just once either but frequently. Heck, even full time professional investors consider 60% success rate as very good. This means that there are many professional investors hitting 50% or less. That is just as well as flipping a coin. The key to a good portfolio is one that maximises those gains, and minimises those losses.

Consider a portfolio of 10 stocks, equally weighted. Six of them decrease at an average of 15% each. These six stocks have a negative effect on our portfolio of 9%.

Now assume the remaining 4 stocks increase at an average of 25% each. These 4 stocks have a positive effect on our portfolio of 10%.        

This means our portfolio gained 1% despite having more losers (6) than winners (4). This is what we main by maximising the winners and minimising the losers.

 

HOW TO CONSTRUCT YOUR PORTFOLIO

1/. Determine the length of time you wish to be invested

2/. Determine your return expectations

3/. Set your investing goals

4/. Determine your risk tolerance

5/. Decide on your investment mix

It is important to know why we are investing. What do we want to achieve? By when? And how do we want to achieve it? Setting these goals as specific as possible will help us determine how much risk we are willing to take to achieve our investment goals.

For example, someone with a 4-year investment timeframe seeking 4% returns, would not be an ideal candidate for a high-risk portfolio. It is too short a timeframe to recover from any losses, and the returns are too low for a high-risk portfolio. 4% can be achieved from a low risk portfolio. In this case, we don’t need the extra risk.

I often see people investing based on lowest fees only. But that is not the right way to construct a portfolio. Fees are important, but not as important as constructing the right portfolio mix to match your goals, return expectations, time horizon and risk tolerance. You should go through steps 1 to 5 above and then AFTER you have decided on what type of investments you want, then should you look at fees. 

For example, not all index funds are created equal. Some put a cap (such as 5%) on any one company. If the biggest company in an index makes up 10% of the index, a fund with a cap may only allocate a maximum of 5% to this company. Whereas, another index fund that exactly mirrors the companies capitalisation in the market will put 10% of your funds towards that company. If the fund with the 5% individual company cap is slightly more expensive than the other index fund and you decide to buy index funds based on price alone, you may end up much less diversified than you hoped, especially if you are invested in a small market like New Zealand with a few large companies in the top ten comprising the majority of your index.

Another example is some mutual growth funds may have 85% of the portfolio in growth assets, and 15% in fixed income. Whereas another companies 'growth' fund with lower fees may only have 75% of the portfolio in growth assets, and 25% in fixed income. If you had a high tolerance for risk but based your decision only on lowest fees, you would end up disappointed with your portfolios lower allocation to growth funds. 

Decide on investment mix first, then compare fees. 

 

WHAT IS YOUR INVESTMENT RISK PROFILE?

If you are afraid of too much risk then you are probably best suited to a well-diversified portfolio consisting of bonds, stocks and cash. The percentage in each comes down to how much we are comfortable with and what type of investor we are:

Conservative investor
Someone that is not seeking high returns, but is more interested in preserving the value of their investments. Commonly invests in lower risk asset classes such as bonds and cash, and possible large well-established stock companies. Conservative investors have a low to medium tolerance for risk and are often uncomfortable with the stock market. A typical portfolio would invest in 80% ‘safe’ assets such as cash and bonds, with the remaining 20% on something a little riskier such as property or local stocks of well established companies. This strategy should protect against inflation, but will not earn much value over time.

Moderate/balanced investor
Seeking a portfolio that has moderate risk and a time horizon of 5 years or longer. Balanced investors are willing to accept a bit more risk than conservative investors, to receive potentially higher returns. A typical portfolio would have an asset allocation of 60% stocks and 40% bonds and cash. The balanced investor may also take a bit more risk with a portion of their investing. Such as investing in foreign markets, or in small cap or value markets.

Aggressive investor
This portfolio is appropriate for an investor with a high-risk tolerance and long term investing horizon of at the very least 10 years or longer. They are willing to accept the ups and downs in account value that come with riskier investments, in exchange for the possibility of greater returns. Typical asset allocation of 80-100% stocks/commodities, 0-20% bonds/cash.

There is a risk questionnaire at the end of this blog that will help you determine what type of investor you may be.

 

FINAL THOUGHTS

As you can see, the type of investor you are and what level your risk tolerance is will determine your investment mix/asset allocation. We shouldn’t always be chasing the best investment or the current ‘hot’ pick. We should be making investment decisions based on our needs and goals. Anything more than that is excess risk.

The secret to a good portfolio construction is accepting that you will never be right all the time. But we can play a part in making decisions that ensure we profit from the things we get right and minimise the losses on the things we get wrong.

In an ideal world we would be able to time the market by selling at the top and buying at the bottom. Since no one can do this it is a loser’s game. We need to accept this and invest in a variety of different asset classes to bet on several winners, instead of trying to pick just one.

In the next article, we will discuss who is best to manage our investments.

 

 

The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here

 

 

RISK PROFILE QUESTIONNAIRE

Question 1 of 10: I plan to take money from my investments in:

  1. 1 year or less                                                                                        
  2. 1 - 3 years                                                                                                         
  3. 3 – 8 years                                                                                                       
  4. 8 – 15 years                                                                                                      
  5. More than 15 years                                                                             

Question 2 of 10: If I owned a stock investment that lost 30% in 3 months, I would:

  1. Sell all the remaining investment                                              
  2. Sell a portion of the remaining investment                           
  3. Hold onto the investment and do nothing                             
  4. Buy more of the investment                                                       

Question 3 of 10: When I make a long-term investment, I plan to keep the money invested for:

  1. Less than 1 year                                                                                                
  2. 1 – 3 years                                                                                          
  3. 3 – 5 years                                                                                          
  4. 5 – 7 years                                                                                          
  5. More than 7 years                                                                           

Question 4 of 10: Generally, I prefer investments with little fluctuation in value, and I’m willing to accept the lower risk associated with these investments.

  1. Strongly Agree                                                                                  
  2. Agree                                                                                                    
  3. Somewhat agree                                                                              
  4. Disagree                                                                                              
  5. Strongly disagree                                                                             

Question 5 of 10: During market declines, I tend to sell portions of my riskier assets and invest the money in safer assets.

  1. Strongly Agree                                                                                  
  2. Agree                                                                                                    
  3. Somewhat agree                                                                              
  4. Disagree                                                                                              
  5. Strongly disagree                                                                             

Question 6 of 10: I would make an investment based solely on a brief conversation with a friend, co-worker or relative.

  1. Strongly Agree                                                                                  
  2. Agree                                                                                                    
  3. Somewhat agree                                                                              
  4. Disagree                                                                                              
  5. Strongly disagree                                                                             

Question 7 of 10: If there were an equal chance of a loss and gain in the next year, I would invest $10,000 in an investment with a 50% chance of:

  1. Losing $164 or gaining $593                                                         
  2. Losing $1,020 or gaining $1,921                                                 
  3. Losing $3,639 or gaining $4,229                                                  

Question 8 of 10: My current and future sources of income are:

  1. Very unstable                                                                                    
  2. Unstable                                                                                              
  3. Somewhat stable                                                                             
  4. Stable                                                                                                   
  5. Very Stable                                                                                         

Question 9 of 10: When it comes to investing, I would describe myself as:

  1. Very inexperienced                                                                        
  2. Inexperienced                                                                                   
  3. Somewhat experienced                                                                
  4. Experienced                                                                                       
  5. Very experienced                                                                            

Question 10 of 10: I need to check how my investments are doing:

  1. More than once a day                                                                    
  2. Once a day                                                                                          
  3. Once a week                                                                                      
  4. Once a month                                                                                   
  5. Less than once a month                                                                

 

TOTAL SCORE
40 - 47: Aggressive
33 - 39: Moderately aggressive
26 - 32: Balanced
21 - 25: Moderately conservative
10 - 20: Conservative
                                                                                            

Explanations:

Aggressive – Heavy concentration on equities. Investor is more open to risk and more likely to see large fluctuations in returns. An aggressive investor seeks higher than average returns. Because of the volatility, it is recommended that the investing timeframe for an aggressive investor is no less than 15 years. 80% stocks/20% bonds*

Moderately aggressive – Also seeking long term investment gains through a mix of equities. Although, the portfolio will contain some conservative investments with slightly less volatility. Recommendation is for an investing timeframe of 8 years plus. 65% stocks/35% bonds*

Balanced – Again, seeking gains from equities, but this portfolio will have a much higher percentage of less volatile investments than aggressive investors. A balanced mix between growth and security. Approximately 50% stocks and 50% bonds*

Moderately conservative – Investor is much less willing to accept variations in portfolio. A moderately conservative portfolio will be more heavily weighted to bonds, than equities. Investment timeframes of less than 6 years should generally be conservative. These assets are not intended to provide great portfolio growth, but to provide security of earnings. 35% stocks/65% bonds*

Conservative – Much more risk averse investors or those with a short-term investment timeframe of less than 3 years. These portfolios hold few, if any equities, and are weighted towards low risk investments such as bonds. These assets are not intended to provide great portfolio growth, but to provide security of earnings. Approximately 20% stocks, 80% bonds*

 

*Note

Stocks don’t necessarily mean stocks. But is referring to investments with higher risk but potential higher returns. Could be stocks, property or commodities.

Bonds don’t necessarily mean bonds. This is referring to investments with lower risk such as bonds, cash or treasury bills.

The percentage allocation doesn’t have to be exact. They are just a guideline to base your investing decisions from.

 

The Investor Questionnaire is designed to help you decide how to allocate your assets among different asset classes (stocks, bonds). You are under no obligation to accept the suggested allocations provided by this questionnaire.

The allocations provided are based on generally accepted investment principles. There is no guarantee, however, that any particular asset allocation or mix of funds will meet your investment objectives. All investments involve risks, and fluctuations in the financial markets and other factors may cause declines in the value of your account. You should carefully consider all your options before investing.