Constructing a Balanced Portfolio
7 minute read
The construction of a balanced portfolio is an extremely important part of your investing journey. A well-constructed portfolio can help you in reaching your long-term financial goals. On the other hand, just making generic investments in assets that you do not really understand can complicate things. If you wish to be successful in your quest for financial independence, you should focus on creating the right portfolio for you and your needs.
Understanding your needs, circumstances, and constraints
Constructing a balanced portfolio is an important task. A task that has the potential to secure your financial future by providing a fixed income to support your retirement, kids’ education and more. It is a prime example of ‘Discipline Equals Freedom’. It might take some research today, and it can be tricky to start, but it’s a decision that you won’t regret in the future.
A well-constructed, balanced portfolio is a general term that needs to be individualised with consideration of your needs, circumstances, and constraints. There are some key questions that you can ask yourself to better understand the above. It is a process that wealth managers call a ‘fact find’. You can perform a fact find for yourself by focusing on the following questions.
- Why do you want to invest?
- Are you preparing for retirement?
- You came upon some extra cash and have no other use for it?
- What is your timeframe? Looking to invest for the short-term (<3 years), medium-term, or long-term (>10 years)?
- What are your capital constraints (how much can you invest)?
- Do you have any outstanding debt?
- What is your risk tolerance?
- What is your risk appetite?
By answering these questions, you will have a clearer idea of your future goals. Most importantly, you will know what it will take for you to get there depending on your timeframe. Based on all your answers, you can design your portfolio by exploring the different asset classes and what each one helps you achieve. A balanced portfolio will cater for your needs, and it will ideally satisfy your risk profile as discussed.
Determine your asset allocation
Let us go through the main asset classes and their different risk profiles. Once you are familiar with the different asset classes available to invest in, you can start creating a portfolio that matches your needs.
Public equities traditionally come with a higher risk return than a few other asset classes. They are also very liquid as they can be sold easily between investors through public market exchanges. They can be both short and long-term investments depending on the company and its industry. Ideal for retail investors as they are often offered with fractional shares and with no constraints on minimum investments.
Bonds give you the opportunity to lend money to governments and corporations. In exchange for your capital, you are promised to be paid back with interest. Government bonds are generally considered a low-risk investment. US and German government bonds, for example, are virtually considered risk-free. However, the return on this type of bond is extremely low. Corporate bonds are, in general, riskier.
Depending on the company, they can get extremely risky but offer a higher return compared to government bonds or lower-risk corporate bonds. Moreover, bonds are usually very liquid if they can be sold in a secondary market (investors buying and selling to investors). Investors often must invest large amounts of money into bonds since capital requirements are generally high. Due to their low returns, bonds are deemed as a longer-term investment and are often used to hedge risk in a well-constructed portfolio.
Commodities are physical goods. Examples include precious metals such as gold, silver and even livestock. For the most part, commodities are a higher-risk investment when compared to bonds, but they bear lower risk when compared to equities. They are very liquid as they can be traded easily between investors. The timeframe of commodity investing depends mainly on the type of commodity while there are no constraints on minimum capital. You can access these assets with very small amounts of money.
Alternative Investments offer a wide range of portfolio solutions. Investor’s options include real estate, private equity/venture capital (including crowdfunding), hedge funds, cryptocurrencies, art & antiques, whiskey and many more. On average, it’s considered to be the riskiest asset class. Consequently, it offers the potential for the highest returns. Most investments in this asset class are quite illiquid and are used by investors with a longer-term timeframe. With the recent introduction of cryptocurrencies, we have seen an increase of alternative investments being used in portfolios as the barriers to entry are extremely low. On the other hand, with hedge funds, the benchmark for minimum investment requirement is exceedingly high. Real estate and private equity/venture capital have higher barriers to entry. However, the recent introduction of crowdfunding is currently allowing retail investors to access these investments from as little as €100.
Determining the right asset allocation for your investing profile will be vital for your long-term financial success. Certain asset classes might suit your needs better than others. However, it is smart to diversify your investments into different asset classes. By not having all your eggs in one basket, you can reduce your exposure to market risk while still enjoying healthy returns in the long run.
Diversify your portfolio
Portfolio diversification is a powerful tool for an investor. It can help you achieve a higher expected return while being exposed to the same level of risk or the same level of return for a lower level of risk.
To diversify your portfolio effectively, it is better to use securities and asset classes that are not perfectly correlated with the rest of your portfolio. Two perfectly correlated instruments will move together in the same direction with the same percentage. For example, when the price of one rises by 5%, the price of the other increases by 5% as well and vice versa. The point of diversification is to offer you some protection. If one of your investments goes down, the other investments will compensate for your losses or even increase your total wealth.
By investing in different asset classes, you can achieve some level of diversification. After you determine the right asset allocation for your needs, you can try to diversify further within those asset classes. Let us use public equities as an example. You might choose to split your investments within that asset class between Large Cap and Small Cap companies. You can also choose to invest some of your money in Developed Markets and the rest in Emerging Markets. All the aforementioned examples are within the public equities asset class but offer slightly different returns based on their level of risk.
Rebalance your portfolio
You are now at a stage where you have done a great job constructing a balanced and diversified portfolio. Markets are moving fast, and therefore it is important to keep moving with them, even if you are using an investing approach that is focused on the long term. Keep an eye out for new opportunities, and do not be afraid to remove securities from your portfolio if they no longer get you closer to your investing goals. Aim at rebalancing your portfolio every 6-12 months by increasing or decreasing your exposure in certain asset classes or specific securities within those asset classes.
As a particular asset class performs much better than another asset class, the percentage allocations in the portfolio will break. The better-performing asset class will share a bigger part of the portfolio. Maybe bigger than what you intended it to be. At the same time, the asset class which is not performing as well, will drop as a percentage of your total portfolio. In this case, make sure that you keep track of the changes so you can then rebalance back to your optimal allocation. We are, of course, assuming that your needs and goals have not changed since the beginning of your investing journey. If they have, do not be afraid to carefully make structural changes to your portfolio by rethinking your optimal asset allocation.
All this might sound intimidating. Nobody is expecting a beginner investor to create the best, well-balanced, diversified portfolio from the very first try. This is a process that will require adjustments along the way. You can never know everything in the world of finance, but you can know enough to take the first step towards financial independence. The most important thing to remember is that you should take it one step at a time, with the first step being to start investing. Your investment decisions do not have to be perfect. Keep educating yourself and try to keep up with news that is relevant to you and your current or potential investments. Use the information in this course to guide you through the process and start building towards a more financially secure future. Whatever your personal circumstances may be, remember that you should not invest more than you can afford to lose.