By Jeffrey C. Simon, CFP®
RBC Wealth Management
Designing an investment portfolio is the process of determining which investment vehicles will help you pursue your personal goals. First, you'll want to identify the personal investment goals that you would like to fulfill. Second, match your goals to the proper investments, commonly referred to as asset allocation. This will resultin a portfolio suited to your investment needs.
One of the first steps in designing an investment portfolio is to identify your personal investment goals. Are you saving for your child's college education or saving for retirement? The goals you would like to achieve through investing will depend upon factors such as your liquidity needs, time horizon and risk tolerance.
Liquidity usually refers to how fast you can convert your investments into cash (or its equivalent). Liquidity needs refer to when you will actually need the cash from your portfolio.
A second factor, which goes hand in hand with investment goals, is your investment time horizon. The length of time that you plan to remain in a particular investment vehicle is referred to as your investment planning time horizon and will have a significant impact on the types of investments that you purchase.
The general rule is: The longer your time horizon, the more risky investments you can make (if they also fit into your risk tolerance). Many financial advisers say they believe that a longer time horizon gives you more time to ride out any market fluctuations. On the other hand, if your time horizon is very short, you will probably want to concentrate your investments in fairly conservative investments. With a short time horizon, you simply don't have time to recoup losses.
The definition of risk tolerance is twofold. It describes an investor's capacity for risk (i.e., how much money can he or she afford to lose). It also describes just how comfortable an investor is with risk. This depends on many factors — objectives and goals, life stage, personality, knowledge and investment experience. Your risk tolerance will play a major role in the investments you choose for your portfolio.
To determine your risk tolerance, you might want to start by considering some basic questions. What type of investor are you? Are you comfortable with risk? In other words, given the unpredictability of market fluctuations, how much of a portfolio drop could you handle without hitting the panic button? Maybe you can tolerate a greater amount of risk in the hope that you'll make out with a better return on your investment. Or, are you the type of person who is going to get nervous every time there is a market drop? By answering these types of questions, you will have a general idea of your tolerance and capacity for risk.
Once you determine your goals, the next step in designing your portfolio is to select the investments that will help you meet your goals, commonly referred to as asset allocation. For example, if you are creating an investment portfolio to save for your retirement 20 years in the future, you may want to select investments that have the potential for significant long-term gain. Conversely, if your retirement is five to 10 years out, you may want to select more conservative investments.
Managing an investment portfolio is not an easy task, but this final step in the investment planning process is key to successful investing. Managing actually encompasses two distinct functions: portfolio management and portfolio monitoring.
Portfolio management refers to the selection of specific investments and the choice of timing to buy or sell, according to your goals and disposition. A higher level of expertise is needed for this than most investors possess.
Portfolio monitoring is an ongoing program that provides you with information needed to evaluate your portfolio's performance and allows you to rebalance the portfolio to keep it on track in achieving your objectives. This function, too, is often left to a professional.
Some time after you have designed your portfolio and allocated assets accordingly, you will probably notice that your original allocations have changed. To maintain your asset class weightings, you may need to rebalance the original allocation.
Rebalancing is not redesigning. Redesigning is a more drastic measure that involves dismantling your old portfolio and starting fresh with a new one, made up of different investment categories. You may want to consider redesigning your portfolio when you are faced with major life changes, such as retirement, or if your investment goals or needs have changed.
Now more than ever, it is important to know what your investments are, whether in your 401k plan, IRA or investment account. The investments that you bought in the past may not be appropriate today.
You may have become more conservative or there may be newer investments that can help you achieve a better risk-adjusted rate of return. I think most investors today are not looking to beat the market so much on the upside but, more importantly, to minimize losses on the downturns.
Jeffrey Simon's website is jeffreycsimon.com and he works at RBC Wealth Management, a division of RBC Capital Markets LLC, member NYSE/FINRA/SIPC.