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Portfolio
What is a Portfolio?
A portfolio is a collection of your investments including equities (stocks), fixed income (bonds), and cash. The amount you hold of each of these is entirely up to you. You will want to consider your risk tolerance, diversification, and your timeline when choosing your investments. Then you will need to create a plan, or asset allocation, that states how much of each investment you want in your portfolio. Let's take a closer look at each of these considerations.
Risk Tolerance
How much risk can you handle? If the stock market crashes, will you panic and sell or will you think of the market as on sale and buy more? If the thought of a market crash stresses you out, then you may want to choose less risky investments. Less risk also means lower returns.
Diversification
Diversification is the act of reducing risk by investing in a variety of unrelated investments so that your entire portfolio is not influenced by a single factor. This principle applies to your portfolio on multiple levels.
You can be diversified by having different asset classes, such as stocks, bonds, and cash equivalents. You can diversify your stocks by investing in multiple stocks. You can make sure those stocks are spread across multiple stock sectors and market caps.
There are 11 stock sectors including energy, materials, industrials, consumer discretionary, consumer staples, healthcare, financials, information technology, communication services, utilities, and real estate.
Market capitalization, or market cap, refers to the size of the company. Large-cap companies are companies with a market value of more than 10 billion. Mid-cap companies have a value between 2 and 10 billion. Small-cap companies are valued between 300 million and 2 billion.
The larger the company is, the more stable it is. The smaller companies are more volatile and risky but offer the chance for greater returns. The more diverse your portfolio is, the less likely it is to be affected by a single influence, reducing the risk of losing money.
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Bonds are similarly diversified by type and maturity. There are different bond types including government, municipal, and corporate bonds. Government bonds are issued by the federal government. Municipal bonds are issued by state and local governments. Corporate bonds are issued by a company. Bond maturity can be short-term, intermediate-term, and long-term.​
Using Index Funds And ETFs To Diversify Your Portfolio
An index fund is an easy way to diversify your investments. An index fund is a mutual fund, or a collection of many stocks or bonds, that follows a specific index, or preset collection, of stocks or bonds.
Unlike an actively managed fund that needs to pay someone to select specific stocks or bonds to include in a fund, an index fund is passively managed by following whatever index it is based on, making it much less expensive to own. One example is the S&P 500. There are index funds that include the entire stock market, as well as index funds that are based on cap weight, stock sector, or asset class.
Exchange-traded funds (ETFs) are similar to index funds, except they can be traded like stocks. A mutual fund allows you to purchase a specific dollar amount of the fund. The price of the fund is determined after trading hours each day. An ETF, on the other hand, allows you to purchase the fund at a specific price per share during trading hours.
This means that if you have $100 to invest, and the ETF share is $80, you will only be able to purchase one share for the price of $80. If you buy the mutual fund, which also costs $80, you will then own 1.25 shares of the mutual fund and the entire $100 is invested. Some companies now allow you to buy fractional shares of an ETF, which lets you purchase based on the dollar amount.
While both index funds and ETFs are tax efficient, ETFs are slightly more tax efficient, which may be beneficial if you are holding the investments in a taxable account.
Pay Attention To Fees
The expense ratio tells you how much a fund costs. The expense ratio is listed as a percentage, which means it costs that percentage of the money you hold in that fund. For example, if you have $100,000 invested, it will cost you $250.00 per year to invest in a fund with an expense ratio of 0.25%. The expense ratio is automatically deducted from the account. In general, it is best to invest in funds that cost less than 0.25%.
Watch for additional fees such as transaction fees charged by a brokerage for purchasing a mutual fund from a competitor. It is often advantageous to buy the fund offered by the brokerage. You should also watch for load fees. These are sales fees or commissions charged when a fund is bought or sold. Most index funds do not have load fees. Less money going towards fees means more money is being invested.
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In a rare, universe-defying twist, index funds, which require less work and lower fees, are more successful than the more expensive actively managed mutual funds over a long period. This means building a diverse portfolio is just a matter of deciding which index funds you want in your portfolio.
Investing In Individual Stocks
Buying individual stocks may seem tempting. It is exciting to guess the next big company. There is no expense ratio, so they are also cheaper to maintain. However, individual stocks are riskier. There is a real chance that you don't choose the next big thing and the company goes out of business. At that moment, you will have truly lost your money. With an index fund, the companies that are not doing well fall off of the index, so index funds are often described as "self-cleansing".
If you are excited about a company, you can choose to invest a very small amount of your money. Limit it to less than 5% of your portfolio. When stock picking, evaluate the fundamental value of the company, and not just its popularity. If you invest in individual stocks, do it with an amount you can afford to lose.
Timeline
Your timeline is another important factor to consider when building your portfolio. When will you need this money? Is your timeline flexible? Do you have time to recover if the stock market crashes? If you are closer to your goal you will want to choose investments that are less volatile and less risky.
Building A Portfolio
Determining asset allocation is the first step in building your portfolio. Your ideal portfolio will be at the intersection of your risk tolerance, timeline, and diversification preferences.
You will need to determine how much of your portfolio you want to have in equities (stocks), fixed income (bonds), and cash. A common guideline is that equities should make up a percentage of 120 minus your age. For example, a 30-year-old would be 90% stocks.
Next your will need to choose your investments. What index funds or ETFs do you want to represent each asset? Here are a few different ways to build your portfolio:
Target Date Funds are the simplest way to start investing. You select a target date fund based on the year in which you will retire. The fund will automatically determine the asset allocation appropriate for your age and slowly transition it into a more conservative allocation as you near retirement. Target date funds can also be used for non-retirement purposes, such as saving for college, by choosing a target date for whatever investment goal you have.
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Pros: No maintenance required.
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Cons: Often become conservative earlier than necessary. Some funds are expensive, and all are generally slightly more expensive than investing in individual funds.
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Tip: Choose a year that is further out than your planned retirement date. This will keep the account more aggressive for longer. Verify that the expense ratio is lower than 0.25%.
Two Fund Portfolios are portfolios made up of a total stock market index fund and a total bond market index fund.
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Pros: Allows you to control the percentage of stocks and bonds on your own terms. Two funds are easy to manage. It is a very diversified portfolio because you own all the stocks and all the bonds.
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Cons: Total stock market funds are cap weighted, which means that a few very large companies make up a large part of the portfolio. The total stock market fund does not usually include international investments.
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Tip: Add a small cap fund and international fund to your portfolio if you want exposure to small and international companies. If you are a long-term investor, you can wait until you are closer to your goal to add a bond fund to your portfolio.
Multi-Fund Portfolios are made up of whatever funds you choose. You can choose small-cap funds, mid-cap funds, large-cap funds, international funds, real estate investment trusts (REITs), corporate bonds, municipal bonds, treasury bonds, or any other fund that you feel is essential for your investment strategy.
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Pros: Allows for more control and opportunities to rebalance your portfolio (more on this later). By choosing different sectors to invest in you are increasing your exposure to smaller companies and international funds if you choose.
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Cons: Rebalancing may be more complicated. There are more opportunities to make a bad decision about your allocation.
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Tip: Don't choose too many funds. If your portfolio is too complicated, you won't want to maintain it. Make sure you don't choose overlapping funds. For example, an S&P 500 (large cap) fund and a technology fund will have overlapping companies. Although you will feel like you are diversifying by having two funds, you are doubling your exposure to the same companies. You want your investments to be unrelated and diverse so that when a negative influence affects one investment, other investments are less affected. If you want to dive deeper and learn more about different types of assets, our blog has a great article on choosing investments.
You can choose a hybrid of any of these plans. For example, you may choose to create a multi-fund strategy for your equities (stocks) and a total bond market for your fixed income.
If you choose the multi-fund method, you will need to determine what percentage you want of each investment and make sure that the total percentage of all of your equities and fixed income matches your asset allocation plan.
Do you want equal exposure to small, medium, and large-cap funds? Large-cap funds are more stable, but small-cap funds offer the possibility of more rewards with more risk. Do you want to include international funds, which can carry the risk of currency conversion and different government regulations but offer another level of diversification?
​Write down your asset allocation plan in terms of percentages of your portfolio.
Asset allocation can change over time because your risk tolerance and your progress on your timeline change. Make sure that you have a plan in place to determine how and when you will transition from a more aggressive portfolio to a more conservative portfolio.
A common strategy for retirement investing is to have a portfolio that is entirely comprised of stocks during the early stages of investing and a portfolio that is 60% stocks and 40% bonds a few years before retirement. I have included my current and anticipated future allocation as an example. Note that I am not a financial planner, so do not view this as personalized financial advice.
You will need to determine what allocation and timeline work for you. If you desire, you can consult with a financial professional to help you determine the best allocation for your personal situation. Whatever allocation you choose, you want to determine your strategy in advance and stick with it so that you do not react to market crashes and make emotional changes to your portfolio. If you try to time or react to the market, you will likely do more harm than good. You can outline all of these considerations in a personal investment policy statement, which is a tool to help you outline your investment strategy and the guidelines that will guide your decisions around investing. Next, let's take a look at different options for managing your portfolio.
