Choosing the right allocation for your investment portfolio is one of the most important steps to manage your risks while also planning ahead for the prospective returns you might get if everything turns out as it should.
The practice of establishing the percentage of the different asset classes and sub-classes that will comprise your portfolio is known as asset allocation and, in the following article, we will provide you with a basic approach to building a portfolio that suits your goals the best.
Identify your financial goals
The first step to take when building a portfolio is to determine which are your financial goals.
The most common goals that individuals and households have include the following:
- Buy your first home.
- Gather capital to start your own business.
- Build a retirement fund.
- Save money for your kids’ college education.
- Pay for a vacation.
- Build wealth.
- Build an emergency fund.
- Receive regular income.
By identifying the financial goal that your investment portfolio is aiming to fulfill you can pick your asset allocation strategy accordingly based on whether you need to put aside money for something or if you need a steady stream of income from your investment.
Once that step is completed, your portfolio will now have a target – usually a certain amount of money – and you can keep track of your progress from time to time to make sure you are on track to hit it.
Word of caution, if you have multiple goals – and the means to save and invest for each of them – you should build separate portfolios for each since your asset allocation strategy might not be the same for building wealth as it would be for paying for a vacation.
Determine your risk tolerance
An individual’s risk tolerance is a qualitative assessment of how much it would affect him/her to see his portfolio face a temporary downturn caused by the market’s systemic volatility.
Understanding your attitude towards risk and to the possibility of losing money is one of the multiple ways to determine your risk tolerance and there are various questionnaires on the internet that can help you in analyzing this aspect of your personality.
This tool provided by Fidelity can help you in determining your level of risk tolerance by answering a few questions in regards to your attitude towards money, losses, profits, and risk.
Traditionally, asset managers and financial planners have five scales when it comes to assessing a person’s risk tolerance. These scales go from risk-averse to risk-taker and your portfolio’s asset mix will vary dramatically depending on the scale in which you fall into.
Establish the percentage of allocation per asset class
Now that you know which are your financial goals and how much risk you are willing to take to achieve them, you can now determine your portfolio’s allocation based on that information.
There are many asset classes in which you can invest in and each of them carries a different level of risk while offering different levels of return.
Here’s an overview of which are the asset classes that you can use to build your portfolio:
- Equities (common stocks).
- Fixed-income securities (bonds, preferred shares, certificates of deposit, etc.).
- Alternative investments (art, collectibles, rights, patents, etc.).
- Real estate and real estate investment trusts (REITs).
- Derivatives (futures, options, warrants).
- Cash & cash equivalents (money market funds, short-term fixed-income securities).
You can allocate a percentage of your funds to each of the asset classes mentioned above based on your financial goals and risk tolerance. That said, make sure you understand the risks and potential returns of each of these assets based on their historical patterns – not their short-term performance.
For example, equities have yielded a higher return than fixed-income securities over the course of more than 50 years while cryptocurrencies, such as Bitcoin (BTC), have yielded higher returns than equities over the last 8 to 10 years.
That said, the volatility of equities compared to cryptocurrencies is significantly lower, which means that equities carry a lower risk than Bitcoin.
Based on that assessment, a risk-averse investor will probably discard cryptocurrencies as a potential asset class within his portfolio while he could also keep the percentage of stocks limited to the low double-digits.
The typical asset allocation uses risk tolerance to determine the percentage that is allocated to each asset class but only includes equities and fixed-income securities, not alternative investments, derivatives, or others of that sort as these asset classes are commonly reserved for experienced investors.
In this regard, here’s how the allocation will look like for investors with a different risk tolerance:
- Risk-averse investor (100% bonds).
- Mildly risk-averse investor (75% bonds – 25% stocks).
- Risk neutral investor (50% bond – 50% stocks).
- Mild risk-taker (75% stocks – 25% bonds).
- Risk-taker (100% stocks)
Which securities should I include for each asset class?
Picking individual stocks or bonds is a very risky undertaking that should be reserved for financial professionals who understand the intricacies of doing this.
If you are a lay investor, you can use exchange-traded funds such as the ones offered by eToro to get exposure to each of the asset classes and sub-classes that comprise your portfolio.
These funds charge a small expense ratio and they can relieve you from the burden of having to choose which individual securities you will incorporate.
Moreover, you can also rely on features such as social trading or CopyPortfolios™ – both offered by eToro as well – to allocate funds into stocks, bonds, or any other kind of security based on the recommendations of other investors who have been successful in their endeavor.
Don’t forget to rebalance periodically
It is important to note that as time passes, the fluctuation in the value of the different instruments that comprise your portfolio will distort the percentage that is allocated to each asset class.
With that in mind, investors should periodically revisit their portfolio to make sure the allocation percentages are being followed. If there are any deviations, the investor can liquidate the holdings that have already outpaced their limit and buy those that are below the pre-defined percentage.