Often times we are asked how we go-about designing an appropriate portfolio allocation for our clients. The answer isn’t as easy as, “you’re young, you can handle the risk” or “you’re close to retirement, so you should focus on maintaining the portfolio.” Instead, we draw from a few different areas, highlighted below, when creating an investment portfolio. When reading this post, it is important to remember that no two clients are the same. Each individual situation may call for a different approach. These are guiding steps only to start the process of creating a portfolio.
Step 1 – Identify goals.
One of the first steps in designing an investment portfolio is to identify your personal investment goals. This step is vitally important. Are you saving up to buy a house? Perhaps you would like to start planning for your child’s college education, or maybe you want a head start on saving for retirement. The specific goals you would like to achieve through investing can help act as a roadmap for how to get started. The more specific you are in this step the better.
Step 2 – Consider liquidity needs and time horizon.
Another factor to consider, which goes hand in hand with investment goals, is your liquidity needs and investment time horizon. Liquidity usually refers to how fast you can convert your investments into cash (or its equivalent). Direct real estate investments, for example – a rental property, tend to be very illiquid, meaning it can take a while to get your money back if you need it. By comparison, publicly traded mutual funds or ETF’s tend to be fairly liquid, so you should be able to get the funds back quicker. To find out your investment time horizon, determine when you will need the money. Ask yourself this question, when do I expect to need the money? For example, if you are saving money for retirement 30 years in the future, your near-term needs from the portfolio should not be very large. However, if your child is starting college in a year, you will obviously need some or all of the “college goal” assets in your portfolio within a very short time. The length of time that you plan to be invested should have a significant impact on the types of recommended investments.
Step 3 – Assess your risk tolerance.
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) and it also describes just how comfortable an investor is with risk. Your risk tolerance should play a major role in the types of investments you choose for your portfolio. In order 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? After all, we cannot control market returns but it is imperative to control “emotions” when market values fluctuate. It is important to be honest with yourself in this step. It is a lot easier to think you have a higher risk tolerance when times are good in markets.
Step 4 – Decide on a target asset allocation.
Once you have completed steps 1-3, only then should you begin the process of selecting appropriate investments (e.g., stocks, bonds, cash) for your portfolio. This “selection process” is commonly referred to as asset allocation. The underlying principle of asset allocation is that different categories of investments have shown historically to have different rates of return and different levels of risk and price volatility over time. By diversifying your investments over a number different asset classes, you should be able minimize risk and volatility. At Cambridge, we like to create a pre-determined Investment Policy Statement in this step. This “IPS” defines specific asset allocation targets to help guide us when managing a portfolio. The target asset allocation process serves as the cornerstone of how we manage money.
In summary, we hope this post provides a starting framework of the steps to consider when creating an investment portfolio. Just remember that creating a portfolio is only the start. Once a portfolio is created and implemented, the next step is managing it, which is another animal altogether. Perhaps a topic for a future post.
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