Key Steps to Building Your Portfolio

Investment Strategy

Key Steps to Building Your Portfolio

Revisiting the basics can build confidence in your financial plan in the face of volatility.

November 10, 2016

In all market environments, it’s important to understand the fundamentals behind your investment strategy, portfolio composition and overall financial plan. Understanding the underlying elements can provide well-founded confidence that may help you avoid emotional responses and stick with your plan in times of uncertainty. With that in mind, let’s examine what goes into constructing and customizing a portfolio that advances your financial objectives and also is suitable for your unique situation.

First Things First

Three essential elements hold up the structure of a well-balanced portfolio: risk tolerance, asset allocation, and that most ubiquitous of investment terms, diversification. And all three complement and strengthen each other.

Your Real Risk Tolerance

One of the most critical elements in investing is accurately identifying your tolerance for risk. Your tolerance informs your asset allocation, which in turn determines how well-diversified you are. Owning a portfolio outside an investor’s comfort zone for risk is a recipe for trouble that often takes the form of selling at or near a market bottom or, on the flip side, loading up on risky securities during periods of market euphoria. In both cases, temporary conditions can cause investors to abandon their long-term plans and make ill-timed and costly decisions.

But honestly evaluating your tolerance for risk can be tricky. A “moderate” risk tolerance can mean very different things to different people. Even a metric that seems precise – “I can tolerate a 20% maximum decline” – may sound acceptable when discussed in a calm office environment but feel very different when the market is acting irrationally. A better approach may be to think in terms of actual dollars. For example, if your latest monthly statement on your once-$750,000 portfolio now reads $598,000, how are you going to react? That’s a 20% decline – not outside the realm of possibility – so if seeing the number in absolute terms raises concerns, it may be time to rethink things with the help of your advisor.

Aligning Risk Tolerance with Asset Allocation

In addition to accurately determining your true risk tolerance, structuring the investment portfolio that’s right for you means revisiting basic considerations such as asset allocation.

Although neither will ensure a profit or guarantee against a loss, asset allocation and diversification are foundational elements of any financial plan. Your true risk tolerance, along with your time horizon, provides guidelines for allocating your capital among different asset classes, and each carries its own level of risk. These include stocks, bonds, cash and other investments.

The classic balanced portfolio of 60% stocks / 40% bonds can provide a good initial reference point, but there’s also nothing wrong with cash, especially for near-term goals. Keeping a portion of your portfolio liquid also can help you remain calm during volatile markets and let you potentially take advantage of possible bargains that may crop up.

Your advisor can be very helpful here, so it’s vital to provide him or her with your total financial picture, including securities you hold in other accounts, property such as vacation homes or boats – anything that represents a significant part of your overall wealth. Bear in mind, too, that market movements will affect your overall asset allocation mix and may require readjusting your portfolio.

Your advisor can help you find the mix that’s best for you at this particular stage of life, as well. Every life event, from graduation to the birth of a child to divorce, should remind you to take another look at your allocation to ensure it reflects your current tolerance for risk.

Although asset allocation can seem complex, it actually proceeds from a simple question: What do you want your money to do? Your answer will largely determine where you are on the risk spectrum.

Time Horizon Comes into Play

When you’ll need the money, your time horizon, plays heavily into what asset classes you include in your portfolio. You’ll likely make different investment decisions depending on whether you’re saving for a short-term goal, like a down payment on a home, or a longer-term one, like retirement. Short-term needs may be met with cash or cash alternatives, like CDs, while long-term plans might require the growth potential offered through equities.

Someone just starting out may be willing to assume greater investment risk as a trade-off for potentially higher returns given the longer time frame available to offset potential losses. On the other hand, others who are approaching retirement or need more liquidity may prefer less risky investments.

Aim for True Diversification

Once you and your advisor have settled on an overall asset allocation, make certain you are well-diversified within each asset class and investment style. Non-correlated investments, those that move independently of each other, can help your portfolio weather market gyrations better, knowing something is likely to gain ground when another asset is underperforming. In addition to tempering volatility, owning a variety of securities can provide exposure to multiple opportunities that could elevate your overall portfolio.

Automate It

Once you’ve got the details down, the second stage is to automate your investing – a way of committing to the plan. There are two benefits here:

  1. Dollar-cost averaging, which allows you to reinvest in your portfolio on a regular basis. You’ll buy some assets at higher prices and some at a discount, thus averaging out your total cost basis.*
  2. Compounding, which is the time-tested strategy of letting your investments continue to grow unabated. As you accumulate more wealth, it in turn may multiply itself over time.

To help set yourself on a disciplined path to reaching your goals, whatever they are, work with your advisor to determine how much to save over each time period and automate those investments to give yourself the best chance of reaching them. Automated investing programs offered by many employers allow you to “pay yourself first” with an automatic monthly transfer to your investment account. Doing so will enable you to “dollar cost average” your investment buys and possibly benefit from the power of compounding. It’s time in the market, not timing the market, that potentially produces results.

Foundational Elements Need to Be Flexible, Too

The financial markets have an endless capacity to surprise, so it’s important to remain flexible and think of your financial plan as dynamic – something built on time-tested principals but also something you revisit periodically and can revise if conditions change fundamentally. Also, be sure your advisor knows about any significant changes in your life and/or your financial objectives, so you both can be sure your plan stays on track.

*Dollar cost averaging does not assure a profit and does not protect against loss. It invovles continuous investment regardless of fluctuating price levels of such securities. Investors should consider their financial ability to continue purchases through periods of low price levels.

Diversification and asset allocation do not ensure a profit or protection against a loss. Investing involves risk and you may incur a profit or loss regardless of strategy selected.



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