The first step in constructing your investment portfolio is determining a goal for the investment. Setting an objective allows you to create parameters that make it possible to determine the rate of return that you will require. The return will be the number that is required to bridge the gap between the amount of capital that you will invest, and your ultimate goal. Once this model has been created, the parameters and the required rate of return can be adjusted in order to arrive at a required rate of return that is plausible, and that fits with your investment style. As an example, if you begin with a principal investment of $5000, make a $100 monthly investment, have a 20 year time horizon, and a goal of saving $100,000, you will require a compound annual growth rate of 8.7%. If it is determined that 8.7% is not feasible, or if it does not fit with your preferred investment style, the parameters can be adjusted. Following the same parameters, if we increase the principal to $10,000 and the monthly investment to $200, we only require a 3.8% annual return to achieve the goal. In the charts below, the green bars are the invested principal and the blue bars are investment returns. Take note of how heavily the person on the left is relying on investment returns to achieve their goal, if the market does not perform as expected they will have a much greater shortfall than the investor on the right.
Armed with an idea of the rate of return that you will need to achieve your goal with your given parameters, the next step is to determine your tolerance for risk. Risk and return are very closely related in that an intelligent investor will not assume more risk than is necessary to achieve a given return, and when more risk is assumed the investor expects to be compensated for assuming it. If we look at the performance of the S&P 500 since 1950, the general volatility of the equity market can be observed.
This chart shows the potential for gains, but it also shows the that capital can be lost in large amounts. If an investor is able to stay invested when the market is in a dip, history tells us that the market will rise again with time. This idea gets much more complicated when we factor in psychology and the time horizon of the investor. If you panic when the market is low and liquidate your investments, you will miss the gains when the market recovers and be stuck holding your losses; similarly, if you have a set date where the capital will be needed and the market is low when you need it you will either be stuck with the losses or not be able to access the capital until the market recovers. The above chart shows the S&P 500 index which is only an example of a group of stocks. An investor can build a different portfolio of stocks that is subject to less risk, they can invest in bonds, they can invest in real estate - there is no shortage of investment opportunities, the challenge is building a portfolio that fits your individual needs and investment style. The following chart from Vanguard illustrates the average returns, and the variability of returns for various portfolios consisting of stocks and bonds from 1926 through December 2012. Selecting a mix of equities and fixed income securities is called asset allocation - asset allocation is how a portfolio is constructed to fit a risk profile.
With the ideas of setting a goal, determining an acceptable level of risk to achieve that goal, and the right asset allocation to meet that risk level, we are ready to begin selecting the securities. Picking individual securities is like going to the casino, or like flipping a coin. The prices of securities reflect all publicly available information, and trying to guess at the new information that may affect the price is not a particularly effective practice. I once had a pension fund manager tell me that even the best analysts are only right 70% of the time. It is, however, possible to reduce the risk and increase the expected return of a portfolio through diversification. Historically, returns of any asset class vary considerable from year to year, and combining assets classes in a portfolio can mitigate this volatility. To further reduce volatility, global diversification reduces the effect of any single asset class or market. The figure below shows the variability of returns across asset classes and geographies, common sense tells us that by combining securities across these asset classes and geographies in a meaningful we can reduce the overall volatility of that portfolio.
At this point we have taken the following steps to construct a suitable portfolio:
- Determined an objective for the investment
- Determined a time horizon and required rate of return to achieve the objective
- Determined a tolerance for risk
- Established an optimal asset allocation based on, time horizon, required return, and risk tolerance
- Diversify away the risks of investing in any single asset class, market, or geography
- The final step is determining a management strategy. There are two ways that a portfolio can be managed; read after the jump.