I got a question the other day, from a reader on this site, as to how I designed a portfolio that helps me target an 8% annual return. That got me thinking about the kind of articles I’m writing on this site. There are some basic concepts about money and investing, that are interesting to cover and which I haven’t yet spent time on. There is also a load of things I still want to talk about around career advancement, and improving our lives, but let me stick to some fundamental finance basics and talk a little about how to go about building an investment portfolio.
To start building an investment portfolio you need to start with two things:
1. Some Money
It all starts with money. Without money you won’t be able to start building a portfolio. This money can take several forms:
– you can use a lump sum of money, say $500 or $1.000 to get started
– you can target a monthly investment of, say, $100
– you can use debt to leverage up your investment. (I’ll come to the concept of leverage a bit later so don’t sweat it for now)
2. A desire to cast off into the unknown
Ok, this is a bit dramatic, but the first step on a journey always starts with the first step and an investment portfolio is definitely going to be a journey. This journey might get you anxious from time to time, it may get you confused and scratching your head and it might even get you to second guess yourself on a regular basis.
But never fear, the Chief Money Man will be here to support you and help steer you through any troubled waters.
So, with that knowledge and a little bit of support, just take that first step.
Step 1: Starting with your appetite for risk
To know which things you should choose to start investing in, and which will become a core part of your portfolio, you need to know a little about risk.
The easiest way to assess how much risk you would be willing to take is to ask yourself a series of questions.
Let’s start with your tolerance to lose money:
A. I don’t mind if I lose money in the short term, as long as I gain in the long-term
B. I don’t mind losing a little money in the short term, as long as I gain in the long-term
C. I don’t want to lose any money in the short term or the long term
Then let’s examine your time horizon:
A. I don’t need the money for the next 15 years
B. I want to draw on my money in 5 to 10 years
C. I want to draw on my money before the end of 5 years
And lastly, let’s look at why you want to invest:
A. I want to aggressively make lots of money
B. I want my money to grow slowly but surely
C. I want my money to be protected
If you’re primarily an A, then you’re probably more of an aggressive investor and looking at accepting short term fluctuations for long term profit.
If you’re primarily B, you’re more of a moderate or balanced investor who doesn’t want big swings in your portfolio but is willing to accept a little risk for slightly more return.
And if you are primarily C, then you’re very conservative and don’t want any or little losses and for your portfolio to be secure and protected from downside.
A Conservative investor is usually someone who takes less risks than average and has an objective to protect their investment portfolio from downside or losses. For less risk, this investor is also willing to accept slower, more gradual returns.
The conservative investor is usually highly invested in bonds or the money market, with maybe a small portion of solid large cap stocks. Stocks usually account for under 30% of the portfolio.
Moderate or Balanced Investor
A Moderate or Balanced investor is someone who is willing to accept some risk for an average return.
This person usually has a portfolio that is balanced between high quality stocks and government and corporate bonds. Stocks may account for about 30-50% of the portfolio.
An aggressive investor is someone willing to lose a significant portion of their portfolio in order to get above average returns.
Usually the portfolio of an aggressive investor is composed of majority stocks, including emerging markets and young companies. Stocks usually account for more than 50% of the portfolio.
Step 2: Designing a portfolio
Once you know which of the above categories you fit into, you can start designing a portfolio that is comprised of either majority stocks, balanced stocks and bonds/money market or minority stocks and majority bonds/money market investments. Use the percentages above as guidelines to structuring your portfolio. They are not absolutes, but give you an idea of a general range to target.
Usually the easiest way to go about doing this for stocks is to invest in index funds. This is a lot less time consuming than trying to pick your way through thousands of stocks or bonds in your country or across the globe. Also investing directly in government or corporate bonds may not be possible directly so funds can be a great way to have access to these assets.
Index funds are investment vehicles that have been built by fund managers to reflect the overall market and hence, the overall performance of the market.
Some of them are very broad, line World Index funds and are built to replicate the performance of the stock markets across the planet. Others might be narrower and reflect a particular country or zone, like the USA or Europe, or even a particular segment of the market, like North American energy stocks or European corporate bonds.
The narrower you go, the more expertise you need, or you might have a passion for a particular area or industry, but I caution you on this as you need more analysis, time and expertise to go narrow.
There is no golden rule on exact percentages and the guideline above are a rough example. Starting out as a Moderate investor, as an example, you might want to go for 40% stocks, 40% bonds and leave 10% in a money market fund. Remember the more stocks you put into your portfolio, the higher returns you could expect, but also the more risk you take on that you could lose your investment.
There is always a balance between risk and return that you need to be aware of, and play with, to find your comfort zone.
Step 3: Knowing what Leverage is
I mentioned earlier that you may look to use debt to finance a part of your investment portfolio.
For beginners to the market or investing, this usually entails some form of real estate investment and using a mortgage loan to buy the property, so let’s use that example to illustrate leverage.
Imagine you take a loan for $100.000 at 4% over a 15 year repayment period. Your monthly payment is $740/month. In Year 1, you will pay around $4.000 of interest, which means you reimburse about $5.000 of capital for a total annual payment of just below $9.000.
If your house or apartment goes up by 3% in value, you make $100.000 x 3% = $3.000.
If you didn’t use leverage, you would have invested an equivalent of $740 / month or just under $9.000 for the year and if that grew by 3%, your return would be around $9.000 x 3% = $270.
So, you can see that using leverage, your return goes up from $270 to $3.000.
This is a highly simplified example to illustrate leverage and it shows the impact in a growth environment. The opposite is, of course, true in a downside example. If the market had fallen 3%, with a leverage investment you would have lost $3.000 whereas without the leverage your loss would only be around $270.
So, leverage increases both your profit and loss potential. It can be powerful but use it wisely.
Step 4: Diversifying
Diversification is the art of not putting all your eggs in one basket, so that if the basket falls, some of your eggs don’t break.
When translating this to investing in stocks, you might consider that instead of investing everything in the USA, you might take some European stocks or Asian stocks. So, if the USA goes sour, maybe the Asian stocks would perform better, and your losses are a little less than if you’d only invested in the USA.
Diversifying is also about using real estate, possibly art, wine, gold and other types of investment assets that help you spread out your investment. It doesn’t guarantee that you’ll protect your investments from losses, but it does help.
Step 5: Choosing a provider
The last step is very country dependent and so I’ll give you some examples below to help you start looking, but you really need to look around in your own market.
In the UK, a service provider that looks like they’re doing some good things is Nutmeg. You can invest with as little as £100/month.
In France, Yomoni or Marie Quantier offer low entry amounts and have created a very simple sign up and portfolio design process.
In the US, Betterment, Wealthfront or Vanguard funds all seem like good places to start investigating.
Starting your own portfolio takes a little bit of time, some knowledge of what you’re trying to achieve and determination to stick with it over a long horizon. It is not hard, but you have to decide that you really want to do it.
Got specific questions? Feel free to drop the Chief Money Man a note and I’d be happy to help.