When looking at your investments, it’s important not to look at all your investments individually, but rather to look at your entire portfolio of investments. It’s quite common for investors to brag about one of their stocks or funds being way up, while failing to mention that everything else in their portfolio is DOWN! That’s pretty silly.
Having a portfolio is for the purpose of diversification–having your money spread out over different assets. If there was no need for diversification, we could all just invest in Coke or Pepsi and sit back and collect the returns. But we never know how a particular security or asset class will perform, so it’s important to diversify so that your entire portfolio will never be seriously damaged by a decline in one investment.
So how do we create a portfolio? Well, it partly depends on your goals and your risk tolerance. Those with a long-term timeline to invest within can usually tolerate morerisk. A portfolio with a high degree of risk but high potential return in the longterm, is often referred to as an aggressive portfolio. An aggressive portfolio may contain 75%
or 80% in equities (stocks) and the rest in fixed-income investments like bonds. Young
people in their 20s who won’t need the money for a long time are likely suitable for an
aggressive portfolio.
On the other hand, some people`s main concern is to maintain wealth they already have and reduce risk. Such people are likely older and have a shorter investment timeframe, and already have money. A young single man in his twenties who has little money yet is really not the best candidate for a conservative portfolio. Conservative portfolios usually consist of mostly fixed-income securities (say, 70-75% of the total assets), while equities play a relatively minor role (around 15%-20% of the total). The remainder is kept in cash or cash equivalents.
And of course there are more balanced portfolios which are somewhere in between, with perhaps 50% kept in equities, 40% in bonds (fixed income securities), and 10% in cash. This is good for the investor with average risk tolerance, who wishes to build wealth while maintaining general stability in his portfolio.
Within those broad categories of equities, fixed income securities, and cash, you diversify even further within each asset class. Having 75% of your money in equities doesn`t mean that you can put that 75% all into a single stock. You might want to diversify across different sectors of the economy (technology stocks, financial stocks, etc.), or diversify into both large and small companies, etc.
So, to determine how to create a portfolio, first you must determine your investment timeframe and your risk tolerance. I, for example, am 30 years old, single, and have an investment timeframe of around 25 years (I plan to retire completely at age 55). I have a high risk tolerance. I don`t care if my investments fluctuate wildly in the short term because I won`t need most of the money for a long time. So I can endure the chaos of the stock market and feel totally relaxed leaving my money in even when the market drops.
What`s your investment time frame, and how much short-medium term instability can you endure?