How to Design an Investment Portfolio
Investment portfolios are the central element of financial plans. They transform hard-earned savings into sufficient funds to cover retirement expenses, college tuition for your children, medical emergencies and other needs. The design process includes setting specific objectives, deciding on the right mix of assets and selecting securities within each asset category. You also need to monitor your investments and make the necessary adjustments to meet your financial objectives. Successful investors focus on the fundamentals and ignore short-term market volatility.
The first step is to set financial objectives, including your investment time horizon and acceptable level of risk. You can afford to take on high levels of risk if you will not tap into your investments for a dozen or more years. A long time horizon not only gives you more opportunities to grow your assets but also to recover from market downturns. However, if you have a shorter time horizon, your risk tolerance is lower because safety of principal and regular cash flow is more important.
The two basic asset categories are stocks and bonds, both of which provide capital gains and income possibilities. Stocks are generally riskier than bonds, but stocks have outperformed bonds over the long-term. A diversified portfolio should contain stocks, bonds, mutual funds, cash and other assets in suitable proportions. The "Perfect Portfolios" section of SmartMoney.com suggests several asset combinations depending on various factors, such as age, number of children and employment status. The mix that is right for you depends on your particular financial objectives and evolves along with changes in your life. Mutual funds offer diversification and professional management at a reasonable cost. Cash assets, such as short-term Treasury bills or savings accounts, do not generate a high return on investment, but they let you take advantage of attractive buying opportunities. Other assets include commodities, such as gold and silver, and derivatives, such as options and futures.
Successful investors buy what they know and understand. For example, famed investor Warren Buffet largely stayed away from technology stocks because he did not understand how to analyze these companies. Security analysis is a time-consuming process that includes reviewing financial results, such as sales growth, margins and cash flow. It also involves listening to quarterly earnings presentations, especially to the second half of these calls when management answers questions from research analysts. Select stocks and bonds of companies that have a lengthy record of generating top- and bottom-line growth. If you do not have the time to research individual securities, you should consider mutual funds or exchange-traded funds, which track specific indexes and trade just like stocks.
Monitoring means reviewing quarterly earnings reports of your portfolio companies, as well as industry and economic data. You could add to your positions if the fundamentals improve or demonstrate continuing strength. However, you should not hesitate to cut your losses if there is an adverse change in the business fundamentals, such as increased competition and new government regulations, or in the economic indicators, such as interest rates and employment. You may also have to re-balance your portfolio after significant market movements. For example, if a market rally increases the stock portion of your portfolio, you could buy bonds and sell stocks to restore the original portfolio mix.
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.