Taking control of our finances can be really empowering – but it can also be really terrifying. So many of the choices we are forced to make today only produce results far into the future and, for some, the risk of error can prevent us from making any decisions at all. It may seem like a game of chance, but it’s not.
The perfect portfolio doesn’t exist. Every investor needs to build their portfolio according to their own specific needs and goals.
In order to build an investment portfolio that’s right for you, start by answering these simple questions:
1. How much time do I have to make investments?
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2. What percentage of my investment capital am I willing to risk?
Be honest and think about it, because the answers will form the basis for your portfolio strategy. Your answers may shift and change over time and so to will your portfolio – so it’s important to revisit your investment portfolio from time-to-time and make sure it still fits your goals. If it doesn’t, you’ll have to build an vestment portfolio that does!
Question Number 1: What is Your Time Horizon
Let’s say you have five thousand dollars to invest. Because it’s invested, it’s not exactly liquid (liquid means you have immediate access to it). Because investments can be illiquid, you need to decide how long can you comfortably go without access to it. Can you wait a year? Four years? Twenty? Since different investments have different time horizons for their returns, you would need to pick assets whose returns match your own time horizon.
Time-horizon can be measured in hours, days, months and years. Philip Fisher (known throughout the industry as the Father of Growth Investments), still owned Motorola stocks when he died in 2004. He believed in the buy and hold approach. Warren Buffet (Earth’s most famous and successful investor), will hold onto certain stocks for decades. In fact, one of his most famous quotes is “my favorite holding period is forever.”
Your time horizon is directly related to your goals – what are you planning on using the money for? At the end of the day, you need decide what the money is for to establish your own time-horizon.
Some good goal oriented time-horizon questions to ask yourself:
- If the money is for your daughter’s college fund: “How long will it be before she turns 18?”
- If the money is for debt repayment: “How much longer till I am completely debt-free?”
- If the money is for a new car: “When do I want to own the car in full?”
- If the money is for a down payment on a house: “At what age do I want to own a house?”
- If the money is for retirement: “What is the last day that I want to work in my life”
As you can see, the answers to these questions are personal determine your time-horizon.
Bottom line: Time-horizon informs your portfolio strategy, so start thinking about it before you invest. Have a clear date and goal in your mind and then you can start building the portfolio that’s right for you.
Question Number 2: What is your Risk Tolerance?
Now that you’ve figured out your time-horizon, you need to determine your risk tolerance (the amount of risk you’re comfortable with). Again, there is no right answer here. You need to determine how comfortable you are with taking risks – like many things in life; the stock market is a game of “risk and reward”.
Your risk tolerance helps define how aggressive your portfolio strategy will be. A “gambler” may be willing to take more chances with his money with the hopes of realizing a bigger payout. On the other hand, someone living pay-check-to-pay-check, straddling bills, responsibilities and dependents, might take a more conservative strategy when building their portfolio.
Question Number 3: Asset Allocation
Do you live life on the razor’s edge or in an insulated bubble? No matter who you are, you need to have your finances in check. That means figuring out where to allocate your investment dollars. In particular, you’ll need to know how to diversify your portfolio, i.e., spreading all your golden eggs in several baskets. Why? So that when something negative happens to one asset or investment in your portfolio, the rest won’t be as affected.
If your risk tolerance is high, i.e., you’re a risk-seeking investor, you can opt to go for a portfolio high in equities or derivatives and low in commercial papers and government securities. Remember that the higher the risk that you take on your investments, the higher the potential returns.
If your risk tolerance is low, i.e., you’re a conservative or risk-averse investor, your ideal portfolio should have the greater chunk of its assets in commercial papers, bonds and government securities, with equities, currencies and the like comprising a relatively small portion. The trade-off however, is significantly lower potential returns.
If your risk tolerance is moderate, you may consider building a more balanced portfolio. This is where the percentages of of your assets allocated to riskier assets like stocks, derivatives or currencies are equal to less risky ones like commercial papers, bonds and government securities. The potential returns on your investments would be somewhere between an aggressive and moderate portfolio.
It’s been said that failing to plan is planning to fail. And when it comes to your investment goals, you need to plan your investment portfolio well. Building an investment portfolio that’s tailor-fit for you and your investment goals require that you answer these 3 important questions:
- how much time you have to achieve your investment goals
- how much risk you’re willing to take in order to achieve those goals
- where to allocate your assets or investment money
The less time you have to achieve your investment goals the more money you’ll have to invest, so its best to start building your portfolio as soon as possible. If you don’t know what your risk tolerance is, you could end up losing more money than you can afford or leaving money on the table by playing too safe. And lastly, choosing where to invest your money wisely can help you not just minimize your investment risks but optimize your potential returns as well.
Ready to start investing, but not yet confident in your ability to build a proper portfolio? Learn more about building an investment portfolio at Wall Street Survivor!