Building an investment portfolio can seem daunting for those who are just beginning their investment journey. It can be difficult to set aside sufficient funds each month, while budgeting for various expenses such as rent, monthly equivalent payments (EMI) for vehicles, and other obligations. However, the sooner you start investing, the more time your portfolio has to mature and grow.
Smart Investing takes into account your current expenses while allowing you to plan your short and long term goals. The most important aspect of building a portfolio is finding a balance between growth opportunities and risks. The trick is to understand your own risk appetite while building a diversified portfolio.
Here are some ways to build a strong investment portfolio.
The first rule of building a portfolio is to spread your investment among different assets, including: stocks, bonds, government securities, real estate, commodities, and cash. Prudent asset allocation can be essential to protect your portfolio from a downturn in a particular asset or market. There are three key aspects you need to consider for asset allocation: your financial goals, your time horizon and your tolerance for risk.
Before you start building your portfolio, take stock of your short, medium and long-term financial goals. Short-term goals are meant to be achieved in less than three years, such as a vacation or renovating your home. Medium-term goals can range from three to ten years and can include goals such as paying for the children’s college education. Long-term goals, like planning for retirement or buying a home, can take more than 10 years to achieve. Our asset allocation should therefore reflect these objectives.
This is the length of time you plan to hold an investment. The investment horizon of the different assets in your portfolio should be decided according to your financial objectives. Your portfolio should include assets that mature over time for short, medium, and long-term goals.
Risk tolerance is the level of risk you can bear and depends on your income, expenses and your willingness to take risks. It may differ from person to person and may also change over time. For example, your risk tolerance may increase as your salary increases and decrease with more dependents and expenses. Risk tolerance can also be influenced by age, as people approaching retirement may be less willing to tolerate high risk.
Risk diversification is one of the cornerstones of smart investing. It is based on the principle that different assets are associated with different levels of risk and involves investing in a variety of assets to minimize the impact of risks associated with a single asset class. Low-risk investments are generally associated with low returns, while high-risk investments often generate higher returns.
By investing in different asset classes, we can strike a balance between our risk and our safety. Diversification must also extend within each asset class. Investing in different sectors and markets protects your portfolio from a sudden downturn in these areas by limiting the damage. Risk diversification dictates that the risks of investing in high-growth stocks for optimal returns should be balanced against low-risk, low-return assets such as market securities or bonds.
Emergency and health insurance plan
Two essential parts of every wallet are the emergency fund and health insurance. Planning for these components is key to protecting your portfolio against unforeseen threats. An emergency fund is intended to help you deal with an unexpected crisis, such as the loss of a job or the breakdown of a personal vehicle. Depending on anticipated expenses, an emergency fund can range from three to six months’ salary.
To ensure that cash is readily available, it is best to place a portion of your investments in cash, such as money market securities such as treasury bills (T-bills) and commercial paper. As government securities, these instruments offer a low-risk balance against higher-risk, but high-return investments like stocks. More importantly, they ensure that you can liquidate part of your portfolio in case of urgent need.
Likewise, adequate health insurance is necessary to protect household savings against medical emergencies. It ensures that you and your family can benefit from health care without compromising your wallet in the event of hospitalization or long-term care. You can also take out supplementary health insurance if your existing medical coverage is insufficient. When planning medical coverage, ensure that dependents, such as parents and children, also have sufficient medical coverage.
Invest in mutual funds with systemic cash flow
Many investors view mutual funds as stable investments where their money is tied up for the long term. While a safe investment avenue, mutual funds with a systematic withdrawal plan (SWP) also facilitate steady cash flow. Under a SWP, investors can withdraw a fixed amount at regular intervals which can be monthly, quarterly or annually. In addition to ensuring regular income from investments, SWP funds also offer investors the flexibility to decide the amount and frequency of withdrawals.
Buy and hold your portfolio, but back it up with a stop-loss order
An investment portfolio is primarily intended for the long term. By allowing your investments to mature over a period of time, you can also allow the associated risks to play out. For long-term investors, a buy-hold strategy can be more beneficial than day trading which requires constant vigilance and in-depth knowledge of the market.
At the same time, it is important to limit your losses through strategies like a stop-loss order. It is an order placed with a broker to buy or sell a security when it reaches a certain price. For example, if your stop-loss is set at 12%, the broker will sell the stock when it falls 12% below the price you paid for the stock, protecting you from any further loss.
Study the market, assess the qualitative risks of an action
To be a long-term investor, you must also invest time in studying the markets and understanding the factors that influence their movements. Major markets include money market, capital market, credit market, foreign exchange market and debt market. RBI policies, inflation, demand and supply are just some of the factors that affect market fluctuations.
In addition, you should also assess the risks associated with any stock before investing in it. For a qualitative risk analysis, you need to consider the context of the business, including its corporate governance and compliance, competitive advantage, brand equity, and presence of risk management practices.
Risks associated with building an investment portfolio
No investment is without risk. Even the most reliable asset can experience an unexpected setback. Portfolio risks can be divided into three broad categories, sovereign risk, loss of principal and inflation risk.
Sovereign risks arise when a government or country is unable or unwilling to honor its debts or loan agreements. This can jeopardize secure investments such as government securities.
Capital loss is the risk of losing the initial investment, or at least part of the initial investment made by the investor. Many conservative investors choose to invest in low-risk assets to minimize the risk of principle loss. However, it is important to understand that every asset carries this type of risk.
Inflation risk is the probability that the returns of an investment portfolio will be lower than its expected value due to inflation. It has an impact on the real rate of return of its investments and is most often associated with fixed income securities and bonds.
Minimize portfolio risk
Risks are inevitable in a portfolio. Therefore, prudent investing emphasizes risk management, to minimize an investor’s exposure to uncertainties through risk diversification. It is considered the most effective strategy for addressing all three categories of risk.
Sovereign risks can be minimized by ensuring that your portfolio is not solely dependent on government securities for stability. Diversifying into stocks also minimizes the risk of inflation risks, while bonds and mutual funds are intended to offset the risk of capital loss. At the same time, investors should also remain alert to market movements. Strategies such as stop-loss orders aim to limit losses when they are unavoidable.
Another key aspect of portfolio risk management is its periodic review and rebalancing. Our tolerance for risk may change over time and according to our income, situation or age. For example, you will be less inclined to take risks with children or as you approach retirement age. It’s important to assess your portfolio to determine the allocation between high-risk, high-return investments like stocks, and low-risk, low-return assets like bonds or fixed income securities.
Periodic review is also necessary to track your investments and the annual growth of your portfolio. Over time, you will be able to better understand the behavior of your portfolio and the best way to improve it. More importantly, it ensures that your portfolio keeps up with your changing needs.
The purpose of an investment portfolio is to ensure your financial stability and independence. It allows you to plan for emergencies, ensure a steady income, and give you the financial freedom to meet your expenses. By setting aside adequate savings each month, we also gain financial discipline and the confidence to make wise decisions about finances and future planning.