What is a Portfolio?

Understanding a portfolio

A portfolio is like a financial report card that shows how you’ve chosen to spend your money. For most people, it’s a mix of stocks, bonds, and cash. But it can also include other cool stuff like foreign currencies, gold, art, real estate, or even investments in private companies. The key to designing a great portfolio is to figure out how much risk you’re comfortable with and how long you plan to hold each asset.

Simple Explanation

A portfolio is your investment pie…

Each asset is like a piece of the pie, no matter what it is – stocks, bonds, mutual funds, ETFs, cash, or something else. The slices are all the same size, just like the whole pie. For example, if half of your money is in stocks, the “stocks” slice would be half the pie. And if the stock prices go up or down, the size of that slice will change too.

What is a portfolio?

A portfolio is like a big picture overview of your investments. It shows all the stocks, bonds, and other financial stuff you own. Ideally, your portfolio should help you get the best return for your risk. The mix of assets in your portfolio should be based on your financial goals and how long you want to hold each one.

Portfolios can be different shapes and sizes. Sometimes, they’re just for one type of investment, like stocks or bonds. But there are some general guidelines for what to include in your portfolio. These usually depend on how much money you make, when you plan to retire, your lifestyle, and how much risk you’re comfortable with. When people talk about their investment portfolio, they usually don’t include things like their house or car.

What is the purpose of having a portfolio?

Portfolios are like a roadmap for your money. They’re designed to help you keep an eye on and manage your investments.

If you want, a portfolio can help you spread your investments around, like stocks, bonds, and other things. By keeping track of each part of your portfolio, you can see if your plan is working for you. Over time, you might decide to buy more of certain things or sell others.

Sometimes, people use target allocations to plan for different goals. For instance, with a financial planner, you might decide how much of your money to invest in stocks and bonds.

Considerations in building a portfolio

Creating a basic portfolio can be as easy as buying a few stocks. Many folks start there. But research shows that building a more purposeful portfolio (one that helps you maximize your returns while managing your risk effectively) involves including a variety of assets. The mix you choose is called your asset allocation.

Here are three main ways to build an actual portfolio:

1. Pick individual assets yourself;
2. Invest in an actively managed mutual fund or exchange-traded fund; or
3. Hire a financial advisor to choose investments for you.

As I mentioned, you can choose your own collection of stocks or mix them with bonds. This is for people who are investing on their own and building their own portfolio.

Another option is to invest in an actively-managed mutual fund or exchange-traded fund (both of which can invest in different assets).

If you prefer, you can also hire a financial advisor (someone who gives you advice on investing and money management) to set up a portfolio for you.

Two important things to keep in mind when building a portfolio are:

1. Knowing how much risk you’re comfortable with, and
2. Understanding how long you have before you need to use the money.

These factors usually work together. For example, people who have a longer time until retirement, like 20 or 30 years, are usually more willing to take risks than those who need to sell their investments soon, like in the next few years.

High risk and a long time horizon: Aggressive investors who have a long time until retirement often invest in stocks and real estate. This is because these investments can give them a bigger return, but they can also be more volatile and risky.

Low risk and a short time horizon: On the other hand, conservative investors are more cautious. They usually want their investments to be stable and predictable, so they often invest in things like bonds or dividend-paying stocks of bigger, more established companies.

Risk: What is specific risk? What is portfolio risk?

Risk is simply the possibility of losing money. Depending on how much you dislike losing money, you might discover your “risk tolerance.” Are you cautious? Bold? Somewhere in between? Based on your risk tolerance, you might decide on your asset allocation to handle the ups and downs of the market.

Individual stocks have “specific risk.” This is the chance that something negative happens that affects one company (e.g., the CEO leaves, a major supplier goes bankrupt, or there’s a product recall). Individual assets, like bonds, also have specific risk.

But there’s also a chance that a part of your portfolio, or even your entire portfolio, could decline at the same time. (This could happen during a recession, or if you’ve invested all your money in a single industry.) The risk associated with your entire portfolio partly depends on your asset allocation and it’s called “portfolio risk.”

A concentrated portfolio can be more risky than a diversified one. It’s like putting all your eggs in one basket. If the market dips, your portfolio could take a big hit. This is true for most assets, like real estate. If you invest mostly in real estate, and the real estate market goes down, your portfolio will probably go down too. This type of risk can be reduced by diversifying your investments.

Your risk tolerance also depends on how soon you want to sell your investments. If you need your money soon, you might want to invest in safer assets. But if you have a longer time horizon, you might be able to take on more risk. The idea is that you have more time to recover from any losses or short-term volatility.

Let’s look at an example. If you’re hoping to buy a house soon, you might want to invest in safer assets like bonds. But if you’re saving for retirement, you might be more willing to take on risk with stocks. While stocks have the potential for higher returns over the long term, they also come with more volatility. So, you have to be comfortable with the possibility of losing money. Remember, investing always involves some risk.

What is portfolio rebalancing?

Over time, the prices of different assets will go up and down. This means your asset mix will probably change. For instance, if stocks have been doing better than other assets, your portfolio might have more stocks (and less of the other asset classes).

Rebalancing is like giving your portfolio a makeover. You’ll sell some assets that are doing too well and buy others that aren’t doing as well. This helps you get your portfolio back to where you want it to be.

But here’s the thing: if stocks haven’t been doing so hot lately, they might not be as big a part of your portfolio as you’d like. In that case, you might want to buy more stocks to get back to your target asset mix.

What is a diversified portfolio?

Diversification is your best friend when it comes to managing risk. By spreading your investments across various assets, you can reduce volatility and smooth out your returns. Putting all your eggs in one basket is a recipe for disaster. For instance, if you only own stocks and the stock market takes a nosedive, your portfolio will likely suffer more than if you had a mix of stocks and bonds.

That’s because most bonds don’t crash as hard as stocks—they’re driven by different factors—and bonds usually provide a steady stream of income. With a diversified portfolio, even if some assets take a hit, your other assets might stay relatively unaffected, helping you minimize your losses. But remember, it’s not always a sure thing—under certain conditions, you could lose everything.

The key to managing risk is finding assets that don’t move in together. If one asset is struggling, you might want to have another one to offset its losses. Diversification is like planning your weekend to account for unexpected events. If the weather’s perfect, you’ll head to the beach. But you might also buy a board game, just in case it rains and you have to stay home. That’s diversification in action!

Diversification doesn’t guarantee a profit, but it can help reduce the impact of losses. A well-diversified portfolio usually includes a mix of stocks, bonds, and cash. Adding real estate, gold, currency, and other assets can further strengthen your diversified portfolio.

Even if you stick to just investing in stocks, you can still get a bit of diversification by owning more than one stock. Back in the 1960s, stock market researchers found that just 10 stocks could help you diversify. But these days, many people think you need more stocks to build a truly diversified portfolio.

In addition to diversifying across different types of investments, you might also want to diversify across different industries. For example, you could invest in companies in the auto industry and consumer staples. Another thing to consider is having a mix of companies in your portfolio, including some that are growing and others that are paying regular dividends. (Just remember, diversification doesn’t guarantee a profit or protect you from the risk of losing money.)

What might a portfolio contain?

No one asset allocation is perfect for everyone. What’s in your portfolio depends on you and your goals. For example, a conservative investor might have more cash and bonds, and fewer big companies.

More adventurous investors might invest in small-cap stocks, growth stocks, or high-yield bonds. Others might buy real estate or other unique investments like commodities or foreign currencies.

Remember, diversification doesn’t mean you’ll make a profit or avoid losing money.