Basics of Portfolio Construction

What is an Investment Portfolio?

A portfolio is a collection of investment assets such as stocks, bonds, mutual funds, and cash or cash equivalents.

Financial Goals and Your Portfolio

Establishing goals is one of the most important first steps in the construction of any portfolio.  You need goals in order to come up with a plan to meet those goals.  Your portfolio is simply a part of the overall plan, and a portfolio is constructed with your goals in mind.

Risk Tolerance

One of the first things you need to do before constructing a portfolio is to assess your risk tolerance.  Risk tolerance is the amount of variability in investment returns an investor is willing to take.  I think your ability to tolerate volatility should also be considered when thinking about your overall risk tolerance.  Knowing your risk tolerance will help you establish an asset allocation, however defining your risk tolerance to begin with can be a bit tricky.  Fortunately, a simple internet search will give you multiple questionnaires that you can use, such as this one from Vanguard.  You can think of your risk tolerance as falling somewhere on a spectrum ranging from low risk to high risk with a corresponding “investment style” from conservative to aggressive.

risk

Asset Allocation

Investopedia defines asset allocation as “an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon.”  Essentially it’s putting together all of the things we’ve talked about so far.  The assets of your portfolio, as well as the allocation of those assets, will align with your risk tolerance, investment time horizon, and financial goals.  Generally speaking, a portfolio with a larger allocation of equities (stocks) would be considered an aggressive portfolio.  While this portfolio would be risky and volatile, the potential for higher returns would be greater compared with a more conservative portfolio composed of more fixed income assets such as bonds.

allocations

An example of the effect of asset allocation on volatility and returns can be seen here.  Note that higher returns and volatility (best year high, worst year low) are correlated with a higher asset allocation towards stocks.  As you shift more towards bonds, your volatility decreases but so do your potential returns.

Examples of Simple Portfolios

The following are some simple portfolio ideas.  As an example, we’ll consider someone with a long investment time horizon and a high risk tolerance who decided that they are comfortable with a 70% equity to 30% fixed income asset allocation.  Since I’m a fan of keeping things simple, we’ll use mainly index funds while trying to keep the number of total funds owned at a minimum.

One Fund Portfolio

These all-in-one funds hold stocks and bonds along with some international exposure.  It’s important to check the actual asset allocation and specific holdings to make sure they align with your target asset allocation and investment strategy.

Two Fund Portfolio

Here you have a portfolio of diversified equities and bonds, all in just two funds.  While you don’t have any international exposure, I think these two funds could serve a lot of people well as the “core” of their portfolio.

This two-fund portfolio gives you exposure to both domestic and international equities in one total-world fund.

Three Fund Portfolio

This will give you a 50% domestic/50% international split between your equities.  If that’s too high you can always decrease the percentage of your international holdings and increase the domestic fund.

Three Plus One (Four Fund) Portfolio

For these you would just add a fourth fund to the three fund portfolio shown above.  The options here are numerous.  You can add a Small Cap fund to tilt your portfolio toward small caps.  You can add a REIT fund to diversify with a bit more real estate.  You can add exposure to International Bonds or TIPS.  You can also add, say a Small Cap and REIT, and create a five-fund portfolio.  The options are pretty much endless.  Here’s an example with a tilt toward Small Cap Value:

 

The White Coat Investor has a good article about 150 Portfolios Better Than Yours.  Check it out if you want more ideas on different asset allocations.

 

 

 

 

Disclaimer/Disclosure Time:  I do invest with Vanguard but I have no financial relationship with them.  I will not receive any money if you click on their links throughout the article.  I’m just a fan of their investment options and low fees.  Also, I am just some random guy online.  I’m not a professional financial advisor/planner.  The contents of this post and blog should not be taken as financial advice and are for informational purposes only.