A portfolio of investments is a combination of different investment assets. Its purpose is diversification. As different securities perform differently at any given time, having diverse combinations makes you less prone to an overall loss. When for example stock prices drop, bond yield might rise and make up for the shares capital loss.
An investment portfolio can include not only financial assets, such as cash equivalents, stocks, bonds but also alternative investments like futures and options. Some portfolios hold in addition real items like art, real estate, precious metals etc.
There are several types of portfolios that consist of different proportions of assets, which depend on the profile of the investor and his goals. Portfolios may be held by individual investors, but also can be managed by financial professionals, banks, hedge funds and other institutional investors.
Common Asset Types in Investment Portfolios
Diversified investment portfolios commonly comprise several types of assets, which can be grouped into major categories based on investment purposes. These include risk-mitigating, return-seeking, and diversification assets.
Risk-Mitigating Assets
As you can judge by the name, this category contains investments that seek to ensure stability and a steady stream of income. They also bring down the volatility of traders’ overall portfolios. This group comprises financial investments like bonds and cash equivalents.
- Bonds are issued by governments, businesses, and corporations as units of tradable corporate debt for the purpose of raising capital. They pay at either flat or variable interest rates (also known as coupons), normally two times per year, until they reach maturity. Bonds usually appreciate in price when interest rates decline or depreciate when interest rates increase.
When a trader purchases a bond they are, in essence, giving the corporation or company a loan. However, they differ from stocks in that they do not entitle the borrower to any ownership rights in the company.
- Cash equivalents comprise a broad category of investments including currencies and treasury bills. They reach maturity in less than one year and are normally associated with lower volatility. This, however, comes at the expense of lower returns. Their biggest disadvantage is that their purchasing power can suffer a dramatic decline during periods of inflation.
Return-Seeking Assets
Return-seeking assets are also known as growth assets and generally come with greater volatility compared to bonds, cash, and cash equivalents. The diversification of such assets across trading styles, sectors, and regions is of essential importance due to the increased level of risk they carry. Popular instruments from this investment category include high-yield bonds and stocks.
- Stocks, or shares, entitle investors to partial ownership in publicly listed companies or corporations and their assets and profits. Those who hold stocks practically own slices of said companies. The size of these “slices” depends on the number of shares one purchases.
The majority of stocks boast high liquidity, which means investors can purchase or sell them quickly and at a low cost. Stockholders are normally paid out in the form of dividends.
Another way to generate gains from stocks is to sell your shares in a company at a higher price than what you originally paid for them. This instrument is suitable for long-term investors and is associated with a considerable level of risk.
- High-yield bonds are also known as junk bonds. They normally offer high gains and carry a considerable potential for appreciation and depreciation, compared to investment-grade bonds. This is largely due to the fact junk bonds pay at a greater interest rate.
Such bonds are typically issued by start-up businesses that have lower credit ratings (under BBB-) because of greater leverage and less stable cash flow. They belong to the category of return-seeking investments due to the fact they come with greater expected return at the expense of higher risk.
Diversification Assets
The category of diversification assets spans a variety of investment instruments including hedge funds, real-estate trusts, hard and soft commodities. The inclusion of such assets can significantly boost the expected return of an investor’s portfolio without increasing the risk level. In fact, such investments can bring down one’s risk without sacrificing their potential gains.
- The real-estate market boasts a greater resistance to inflation compared to the bond and stock markets. Real-estate investment trusts (REITs) allow individual market players to gain dividends from investments in the real-estate market without the necessity of purchasing any real-estate properties.
Such trusts are known to offer high liquidity, which causes them to yield high and stable income. Similarly to bonds, these trusts demonstrate greater sensitivity to the changes in interest rates. Like stocks, REITs can carry higher risk but investors are compensated for this by their potential to bring in bigger returns over the long run.
- Hedge funds are partnerships between multiple investors who pool their capital together to invest in different categories of financial products. The funds are run by professional fund managers who implement different trading strategies on behalf of the other investors.
The primary goal is to maximize the investors’ gains and reduce or altogether eliminate risk through various hedging strategies. One needs to cover specific requirements in terms of net worth (of at least $1 million) to be allowed to join a hedge fund.
Another common feature of these funds is that they often utilize borrowed capital in the form of leverage to increase their returns. The fund managers commonly go short to capitalize on price drops. The annual gains hedge funds yield can differ wildly depending on the market competence of the managers and the type of hedge fund.
- Hard and soft commodities are another way to add versatility to your trading portfolio. Hard commodities comprise resources from nature that are extracted or mined including the likes of silver, gold, platinum, oil, natural gas, and rubber.
The category of soft commodities contains livestock and agricultural produce like sugar, soy, orange juice, coffee, cocoa, pork, and corn, among others. The commodity market can be very volatile because prices move proportionately to inflation rates.
Pie Chart Representation of Investment Portfolios
Each investor builds a portfolio that suits their needs and risk profile. The monetary value of each asset influences the risk-reward ratio of the portfolio and is referred to as asset allocation of the portfolio. It aims to maximize profits while minimizing risk exposure. Many experts suggest the best way to imagine what a portfolio looks like is to think of it as a pie chart, like the one below.
Each section of the chart corresponds to a different asset. According to the choice of asset allocation, an investor can build several types of portfolios that generally follow two basic directions – conservative and aggressive.
Conservative Investment Portfolios
The conservative concept operates in a much shorter time-horizon and puts safety as its main priority. It is mostly appropriate for risk-averse investors who rely on sure and regular short-term cash flows. Such portfolios mainly consist of cash, cash equivalents, and quality fixed-income instruments.
Their main goal is to maintain the real value of the portfolio by protecting it from inflation. The purpose here is to safeguard the principal value of one’s investment portfolio, which is why this model is commonly called a capital preservation portfolio. One example of investment allocation is 70% – 75% fixed-income securities, 15% – 20% equities, and 5% – 15% in cash and its equivalents.
Building a moderately conservative portfolio is the right fit for traders who seek to shield most of the overall value of their investments but can still tolerate some level of risk to protect themselves from inflation.
Current income investing is a suitable strategy in this case. With this approach, the investor selects securities that offer higher payments in terms of coupons or dividends. One such portfolio can consist of 55% – 60% investments in fixed-income securities, 35% – 40% equity investments, and 5% – 10% in cash and cash equivalents.
Aggressive Investment Portfolios
The aggressive concepts are mostly suitable for investors with high-risk tolerance, who aim at the highest possible profit. The goals of such market players are high returns over a long-term period, mainly from equities such as stocks.
Thus, the purpose of building an aggressive portfolio is to achieve massive gains at the cost of the huge risk that comes with large returns. Stock investors who rely on this style of portfolio management look for businesses that are still in the initial stages of development and growth.
Such companies are yet to become household names. Aggressive traders would seek out stocks that have high beta levels and suffer greater price shifts compared to the overall market.
It makes sense managing one’s risk adequately is of utmost importance for those who choose to build aggressive portfolios. So if you pick this investing style, you should strive to capitalize on the rapid growth of emerging companies that are still unknown to the average retail investor.
Other Common Types of Investment Portfolios
Following the above noted basic concepts of portfolio forming, we can further look into a more detailed, but still overall common classification of portfolio types and suggest three of those – hybrid, income, and speculative.
Income Investment Portfolios
The focus with this type of portfolio falls on ensuring a constant flow of additional income from one’s investments rather than focusing on massive gains in the short term. Here is an example of how one such portfolio works. Suppose you and your spouse collectively earn $100,000 per year but unexpectedly come into an inheritance amounting to $1 million.
You and your significant other decide to build an income portfolio and invest your entire inheritance, using a strategy that produces 5% in annual returns. This way, you can potentially generate $50,000 in extra profits per year, bringing your overall annual household income to $150,000.
Income portfolios are a great fit for people who find themselves receiving substantial amounts of money, be it from an inheritance, selling a property, or winning a big jackpot. Building one such portfolio can help them earn additional income. The allocation of assets varies between income investors but diversification is highly recommendable.
Such portfolios often contain stocks from blue-chip corporations like Pepsi Cola and Apple that pay high dividends. Investors who choose this approach would sometimes throw different types of bonds into the mix based on the tax features of their accounts. Although more volatile, real-estate investment trusts are also incorporated into income portfolios as they have the potential to yield substantial wealth.
Speculative Investment Portfolios
Speculative portfolios are associated with significantly higher levels of risk so much so that some investors compare trading with speculative financial instruments with gambling. In fact, this is the primary difference between investing and speculating. However, speculators are different from gamblers in that they strive to make educated decisions about the direction in which their positions will move.
They are willing to take on significant risk in the name of generating outstanding returns from transactions that may move one way or the other. Speculators are keen on implementing derivatives like options and futures into their portfolios.
It is typical for them to adopt short-selling strategies, which results in frequent closing and opening of positions. There are several main types of speculators, including day traders and swingers.
As for the speculative portfolio, traders are generally recommended to refrain from using more than 10% of their assets on speculation. Extensive research is vital for every successful speculator.
Hybrid Investment Portfolios
The hybrid portfolio gives traders greater flexibility since it requires them to invest in a motley range of financial instruments like hard and soft commodities, bonds, and real-estate investment trusts (REITs). One such portfolio can comprise blue-chip stocks in combination with top-of-the-line corporate or government bonds.
A smaller portion of the portfolio’s assets can be made up of real-estate investment trusts and master limited partnerships (MLPs). There is a relatively proportionate mixture of bonds and stocks in one such portfolio.
One of the biggest benefits of this technique is that it allows for diversification across numerous classes of assets. The advantage here results from the fact fixed-interest securities and equities tend to exhibit a negative correlation between each other.
Factors to Consider when Creating Your Investment Portfolio
The choice of portfolio type and the allocation of assets in it are determined by a variety of factors including traders’ individual risk tolerance, their investment goals, and their chosen time horizon. One’s knowledge of different industries, markets, and businesses also matters.
- Different investors have different goals. You should sit down and consider what you want to accomplish as an investor. For example, are you trying to amass substantial wealth or are you looking to preserve what you already have?
Long-term investors tend to choose long-term instruments like stocks, unit-linked insurance plans, and debt mutual funds. Conversely, those who concentrate on short-term trading typically go for less volatile debt securities like government bonds or liquid mutual funds.
- The term investment horizon denotes the period during which a trader holds on to an investment. It is influenced by one’s investment goals and the strategies they prefer to implement.
Long investment horizons (eg. 5 or more years) are inherent to traders who build more volatile portfolios and adopt a more aggressive approach. And vice versa, short-time investment horizons are intrinsic to more conservative investors with lower risk tolerance.
- The term risk tolerance refers to the degree of uncertainty different investors can tolerate to potentially generate greater profits. This factor is crucial since it influences the allocation of financial assets in one’s portfolio.
A financial expert or advisor can quickly determine your risk tolerance by simply looking at the assets your portfolio consists of. Conservative investors with low risk tolerance show inclination toward choosing large-cap or mega-cap stocks, cash and cash equivalents, etc.
The opposite is true of aggressive traders who boast high tolerance to risk. They tend to incorporate more volatile investments into their portfolios, such as commodities, small-cap stocks, and high-yield bonds.
- Investment knowledge and individual net worth also bear consideration. Your investment choices should be based on your level of experience and know-how. Novices with rudimentary knowledge often resort to hiring financial advisors who pick investments on their behalf. One’s personal income also plays a role because some investments are costlier than others.
Tips to Build Your Investment Portfolio
Complete rookies are better off choosing a wealth management platform and hiring a professional financial advisor. Experienced investors often prefer to build their portfolios on their own to avoid the extra costs. Either way, the tips below might prove useful.
- You must first decide what your objective of creating the portfolio is in the first place. This will give you a direction regarding the types of investments you should incorporate in it.
- Consider the extra costs associated with the trading transactions. Short-term trading involves opening and closing multiple positions within a short period. It makes sense such high-frequency trading might cause you to rack up greater expenses over time. Another thing to take into account is that some forms of investment require more time until they eventually start yielding returns.
- One thing to refrain from is pouring way too much of your capital into a single asset. Keep in mind that the break-even point of a given investment is proportionate to its price. When the price is greater, it will take more time for you to break even and start generating profits. And vice versa – the investment will yield higher returns when the asset’s price was lower.
- You should not rely on one investment only. Portfolio diversification is crucial to the success of all ambitious investors. Remember that holding a versatile spectrum of investments helps reduce your overall exposure to risk. While some of them are performing poorly, others might be on the rise.