This article will be the first in a series of articles dedicated to building a decent investment portfolio.
Let me start by saying there is never only one way to build a portfolio. My articles will generally describe methods that I consider to be effective. Large parts of these articles are therefore highly subjective and don’t necessarily reflect your preferred methods for building a decent portfolio. My first tip is to stay critical and always evaluate your own opinion against mine. I’m only human and still learning, so there might be better methods than the ones described here. Still, every investor has to start somewhere and my hope is that these articles can help with those crucial first steps on the market.
The first part of building a successful portfolio is to define a decent plan. Although every plan is different, core principles of every portfolio are to make money and to reduce the risk of losing money as much as possible. How to get there differs from person to person. Defining a plan can help to make clear why you want to invest, what you want to invest in and what to do when things go wrong.
It can also help to create boundaries for your inside speculator, so you don’t slowly convert from calm investor to hyperactive gambler.
Defining a goal
Every great plan starts by defining a clear goal.
Ask yourself why you want to start investing. You want to become rich as soon as possible or just want to retire a little earlier? Maybe you want to invest to buy a nice car in ten years, without needing a loan?
Define your goal as clearly as possible. Try to estimate the minimum yearly rate of return you want (or need) on your investments, but try to stay realistic. The higher the return on investment must be, the more risk you will need to take to get there.
Choose your approach
When your goal is defined, you can choose an approach. Generally there are two approaches: a passive and an active one.
The passive investor normally doesn’t spend too much time investing and just sits back and relaxes while his investments grow in value.
The active investor usually takes a more offensive approach. He or she actively follows the market and its developments and tries to make sound investments after hours of research.
Your chosen goal directly affects the approach you need to take. If you want a high rate of return, than you automatically need to take an active approach. Research is needed to ensure you make solid long term investments to actually achieve the desired rate of return year in, year out. This is especially true if you want to beat the market, which is difficult even for professional investors. It’s not enough to take the passive approach when wanting a high return on investment. The passive approach is perfect for people wanting a modest rate of return.
Choose your tools
After choosing a goal and an approach, you can look at the usable tools to build a portfolio. The available tools are mentioned in one of my previous articles: The five investment categories.
In summation, the tools are: cash, bonds, stocks, real estate (plus related funds) and alternative investments (plus related funds). How to choose the right tools for the job will be covered in upcoming articles in this series. For now it’s enough to know two important strategies: build your defense first and diversify your portfolio.
When writing your plan, try to spread your investments over as many of the tools as possible. Investments with good liquidity and low risk are the defensive part of your portfolio and should always be present in any portfolio. As mentioned before, in upcoming articles I will explain why I think these two strategies are very important. For now, try to make a list of the tools you want to use and make an estimation (in percentages) of how much of your budget you want to invest in that particular category.
As an example, this was the list I made for myself a year ago. This particular portfolio is considered relatively offensive:
- Cash: 15%
- Bonds: 25%
- Stocks: 50%
- Real estate & alternative investment funds: 10%
Evaluation and maintenance
Times change, markets crash and companies die. Unless you have an extremely defensive portfolio, it’s good practice to evaluate your plan periodically and make necessary changes.
If for instance it seems impossible to get the desired rate of return, it might be time to change your portfolio completely. The same is true if you are a proud holder of stocks that perform extremely well. It’s nice that these corporations do well, but the added effect is that high risk offensive parts might weigh heavier on the defensive part of your portfolio than initially desired. If the high risk parts outweigh your defensive parts, than take action to repair the balance.
Your personal life might change, which could mean your entire plan is no longer viable. In that case the plan itself should be evaluated. In any case, make sure to check your plan and portfolio from time to time and evaluate if things are still going the way they should.
When evaluating your plan, make rules for adjustments. As an example, here are some evaluation rules I set up for myself:
- Investments in single companies should never exceed 15% of the entire portfolio. Partly sell if that is/becomes the case.
- Never compromise cash to buy tempting investments.
- Bonds (plus related funds) should always be 25% of the portfolio, with a standard deviation of 5%.
- Stocks from companies with bad news about scandals or blundering management should be sold immediately, without question.
- Dividend needs to be reinvested, preferably in the company that issued it.
Conclusion and outlook
This first part in a series of articles explained how to make an investment plan and why it’s a good idea. Making a plan and living by it ensures you never give your inside speculator a chance. It keeps you from making rash decisions based on temptation and ensures you never lose track of the goal in the long term. The upcoming article will explain how to build your defenses and the reasoning behind the importance of it.