How to Construct a Portfolio
Constructing portfolios is fun. Your portfolio expresses your investing views, your beliefs and even your ethical views.
- Maybe you believe tech stocks will continue to revolutionize the world and want a heavy exposure to them.
- Or you really care about certain sustainability goals and only want to invest in companies that help further those goals.
- Maybe you are working towards FIRE and seek income-producing assets.
- Or you are an active option trader, and your portfolio is a high-risk/high-gain basket of call and put options
- Whatever is your style, portfolio construction helps you express who you are through a basket of assets.
Here are 4 steps to building and maintaining a successful portfolio:
- Decide how much you are investing
- Selecting in what you wish to invest
- Determining how to allocate your capital
Decide how much you are investing
The first step of building any portfolio is to understand how much capital you want to invest, and why you are investing.
On the one hand of the spectrum, if you’re investing for the long run you will probably add to your capital a portion of your savings each month, and invest in a balanced portfolio.
On the other hand, you might decide to invest a portion of your assets that you can afford to lose in high risk / high return assets - knowing you could lose it all.
Choosing how much money to invest depends on your investment profile (your age, income, investment goals), which also has an effect on your risk tolerance.
In terms of character, an investor who aims to earn an income versus an investor who trades as a hobby would have very different risk appetites and hence, asset allocations. The former would look at lower risk-lower return assets (like bonds and exchange traded funds) while the latter, investing as a hobby, would be willing to invest in high risk-high return assets (like equities and cryptocurrencies). Therefore one must carefully study their present situation and future financial goals before investing their money.
Selecting in what you wish to invest
Based on an investor’s strategy, their choice of assets and capital allocation will look different. Different assets carry different amounts of risk: assets like bonds carry less risk than equities, because of their hierarchy in the repayment line, if a bankruptcy were to occur. Additionally, a lot of bonds are backed by the guarantee of governments and large corporations.
You can further break down asset classes into different subclasses, based on their different risk and return profiles. For example, equities can be classified based on different industries (which carry different risk) and bonds can be classified based on time horizon (short term vs long term). Remember to analyze the different factors (risk-return profiles) before allocating capital to assets.
Deciding how to allocate your capital
An asset’s weight in the portfolio is defined by the amount of capital invested in a specific asset divided by the total amount of capital invested.
The choice of portfolio weights is one of the major decisions in portfolio construction. And it is not a one-off action: over time these weights will have to be reassessed and rebalanced due to changes in the investing environment as well as in your future financial goals or risk appetite.
For example, a salary promotion or an inheritance might provide you with a cushion and decrease your risk aversion , motivating you to increase allocation in stocks for the long term.
Rebalancing simply means bringing the weights of the portfolio in line with your desired levels.
Once you’ve decided which asset classes to rebalance, it’s time to dive into the asset classes and decide which specific assets to rebalance. As mentioned before, asset classes are divided into subclasses, which hold different risk-return characteristics. If you choose to reduce your risk exposure in equities, maybe you choose to reduce your allocation in pharmaceutical companies and increase your allocation in high-dividend paying utilities. In terms of bonds, you may switch between corporate bonds and government bonds for more financial security.