- Elon Musk, Investor & Entrepreneur
Entering the world of investing can be a daunting task. It seems like a scary place with its own rules and its own convoluted terminology. This alone can feel like a foreign language to those unfamiliar with the investing industry.
But while investing can be a complicated affair, getting started with investing is relatively easy. You just need to learn a few terms and some basic tips. Let’s start here with the concept that binds all of your investments together — the investment portfolio.
INVESTMENT PORTFOLIO DEFINED
An investment portfolio is the collection of all your assets bundled together with the goal of earning a return and growing in value over time. Your investment portfolio includes all of your stocks, bonds, mutual funds, exchange-traded funds (ETFs), real estate holding, and even cash. But an investment portfolio isn’t a physical thing. It’s more of an abstract concept, a way to easily view your various investments and keep track of their performance over time.
There are different types of investment portfolios. For example, some are part of a 401(k), annuity, or some other retirement plan. Others are held at brokerages or with a financial advisor.
Generally speaking, your investment portfolio may contain any number of different assets. For instance, you may own an individual retirement account (IRA), a 401(k), an account at a brokerage, and a high-yield savings account at your bank. Combined, these comprise your investment portfolio.
Building a portfolio involves several factors, but the biggest of these deals with your risk tolerance.
TAKING A RISK
When building an investment portfolio, one of the key components to think about is your personal risk tolerance. This is your willingness to take on losses in your investments in exchange for potentially higher earning returns.
Some investments, like stocks, can be somewhat volatile and often carry high risk. Fixed-income securities like bonds and certificates of deposit (CDs) make for safer investments. And if you’re in a position where you can’t afford to lose any of the money you invest, a high-yield savings account, which is very low risk, may be the best option.
When it comes to risk, there are some factors to consider. One is how much time you can spend investing before you reach your financial goals. If that goal is years in the future, you have more time to weather the highs and lows of the market. Generally speaking, the longer you stay with an investment, the more you can take advantage of the overall upward progression of the market.
For example, a 30-year-old investor may be willing to accept more risk in their retirement portfolio than a 60-year-old investor. However, another facet of risk assessment is how well you can handle watching the market fluctuate year over year. If such potential losses make you nervous, then a high-risk portfolio may not be for you.
TYPES OF INVESTMENT PORTFOLIOS
Risk assessment is very important when building a portfolio. High-risk investments can make a lot of money, but they can be volatile, so losing money is a possibility as well. Conversely, low-risk investments don’t typically offer large returns, but it’s harder to lose money when the market performs poorly.
If your risk tolerance is high and you have a lot of time for your investments, then an aggressive portfolio might be for you. On the other hand, if you have a low risk tolerance and only a short time to invest, then you may be more suited to build a conservative portfolio. If you fall somewhere in the middle, then the answer might be a moderate portfolio that balances aggressive investments like stocks with more stable commodities like bonds.
No matter which type of investment portfolio you prefer, it’s important to diversify what’s inside of it.
HOW TO DIVERSIFY
If you’ve invested heavily in one investment and it quickly grows in value, that’s a good thing. But the opposite can also happen — that same investment could rapidly lose value. And that means your whole investment portfolio loses value along with it.
That’s why it’s important to diversify your portfolio. This means that you make sure your portfolio contains different types of investments. These are also known as asset classes. If you build a portfolio with some stocks (a high-risk asset class) along with some bonds (generally a low-risk asset class), you’re protecting yourself against big losses.
Now when your volatile stocks drop in value, your investment portfolio still has value thanks to the bonds it’s holding. Diversifying your portfolio in this fashion is one way to mitigate risk.
You can also diversify your portfolio within asset classes, like stocks, for instance. If you want to diversify an all-stock portfolio, it’s best to choose assets across a wide range of companies and even different industries. That way if your manufacturing sector stocks, for example, lose value, your technology market stocks may remain stable. This level of diversification can get complex quickly and requires a lot of research.
MANAGING AN INVESTMENT PORTFOLIO
Once you’ve gone through a personal risk assessment and decided on the type of investment portfolio you’re comfortable with and populated it with a diversified set of asset classes, it’s time for the next step — management.
Managing an investment portfolio can be as easy or as complicated as you want it to be. There are two main options when it comes to portfolio management — active management and passive management.
Active portfolio management is most often done by a portfolio manager (or a team of them) who makes decisions about your portfolio based on prevailing market conditions while taking into account your risk tolerance.
The advantage of working with a portfolio manager is that this is a professional investor, one who watches the market and can act quickly when there are changes. Active management comes with a cost (in the form of fees) but can earn big returns if managed well.
Passive portfolio management is typically performed by an individual owner of a portfolio. The advantage of this method is it’s less expensive than active management, but the returns are typically more gradual.
If you’re managing your own portfolio, it’s important to rebalance it once a year. This means taking a look at how your balance of asset classes has performed and making any changes you feel will keep your portfolio in line with your risk tolerance.
THE BOTTOM LINE
Investing is never a fool-proof process. When building your investment portfolio, your best plan is to consider all the variables like your income, your age, how long you have to invest, your personal risk tolerance, and your overall goals. These concepts make up the foundation of a well-built investment portfolio.
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