What an investment Portfolio Means and How to Build it
An Acceler8now.com Investing Education Resource July, 2007
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An investment portfolio is a set or collection of investments held by an investor. It is a basket of financial assets which may include stocks, bonds, mutual funds, commodities (say gold), real estate, money market instruments or other securities. An investment portfolio is built to meet certain investment objectives of the investor. Because each investor's expectations, circumstances and risk outlook are different, there is the need for a portfolio that fits his investment profile. More appropriately, a portfolio reflects the objective of risk diversification - a collection of investment assets selected to minimise portfolio risk or, better put, to maximise expected return for the investors risk preference level.
Why it Matters
The need for a 'diversified portfolio' of investments is rooted in the reality of the riskiness of all investments. If investments were without risk, an investor would more conveniently channel all his resources into one investment outlet, say a particular company stock, which he adjudges as offering the returns potential he expects. The reality is that returns are subject to variability due to factors that affect the market as a whole (systemic risk) or the particular security (unsystemic risk). This variability of returns reflects the risk profile of the investment i.e. the likelihood that the returns will vary from expectation. It is to mitigate the impact of this risk (that is, to hold returns as close as possible to the investor's expectation) that different assets from different classes, companies, sectors of the economy and even regions of the globe may be built into a 'basket' that diversifies out some risk, leaving a safer investment bundle. That is, the extremes cancel out, giving a less volatile returns expectation.
What You Need to Do
Simply put, as investor, you need to select a set of investments that will ensure that you don't easily lose money or earn poor returns. You will carefully decide how to spread your money among stocks and other financial assets that are not subject to the same influences. That selection process is called portfolio construction and the objective is to achieve portfolio diversification. The idea of correlation of returns is important as the aim is to pick securities that are not positively correlated. Correlation means that the investments are affected similarly by the same variables. Take an extreme case: your investments are in stocks and in the pharmaceutical and food sectors only, because you find them performing very well. Suddenly NAFDAC gets a weaker management that allows drug-faking, unwholesome food imports and other abuses to assume full dimension again. The companies in those sectors suffer a major downward spin in earnings, leading to massive loss of value. Your portfolio will suffer greatly because your investments are subject to similar influences. You did consider diversification while investing.
How to Proceed
Most investors, before now, just bought stocks, without a deliberate portfolio plan. It can't be said that it can't work. What doesn't work is not investing at all. However, there is access today to more knowledge and information that can help you accelerate your overall performance and, in this case, invest more safely. That is why you have to consider building tested investment strategies into your investment process. For instance, seeking to achieve portfolio diversification. To do this you need to construct your portfolio which simply means designing the shape of your ideal portfolio: what financial assets it should include, in what proportions, from what subsectors, down to what specific items (example: what specific companies in the case of stocks). Here, you are deciding what you want your portfolio to look like, by design. This is clearly different form just buying stocks as buying opportunities arise and possibly ending up with, say, 80% of your investments in bank stocks, just because you consider them profitable. Yes, that could mean good returns now. But what if, overnight, something serious happens to that sector and leads to significant decline in bank share prices? Poor, undiversified portfolio! A seasoned investor wants to make money now but wants to remain in the black, not red. Spread your risk with a deliberate portfolio plan. Read more on getting your portfolio into shape in these articles "What experts expect in a diversified portfolio" and "Building Your Stock Portfolio, One Step at a Time".
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