How to Build an Investment Portfolio: Plan, Research & Diversify

Conventional wisdom tells us not to put all our eggs in one basket. Another school of thought suggests doing exactly the opposite, but then watching that single basket like a mother hawk.

When you think about it, though, the latter kind of investor – those with a financial portfolio that consists mainly of one type of asset – is bound to stumble and bear losses sooner or later.

Regardless of anyone’s best intentions, all investments that can yield a decent return can also lose value.

That’s why you need to know how to build an investment portfolio; for beginners, this largely revolves around diversification.

Table of Contents Table of Contents

1. Key Takeaways
2. How to Build an Investment Portfolio: Step-by-Step Guide
3. A Contrarian View: When the Best Investment Portfolio Isn't Diversified
4. The Bottom Line
5. FAQs
6. References

Show Full Guide

Table of Contents

1. Key Takeaways
2. How to Build an Investment Portfolio: Step-by-Step Guide
3. A Contrarian View: When the Best Investment Portfolio Isn't Diversified
Show Full Guide
4. The Bottom Line
5. FAQs
6. References

How to Build an Investment Portfolio: Step-by-Step Guide

The word “portfolio” means the mixture of different investments each of us holds.

While you may have a preference for certain types of investments, for example tech stocks, it’s essential to include a variety of assets to achieve a well-balanced portfolio.

However, this doesn’t exactly tell you how to build a portfolio that’s going to meet your particular needs.

Your needs are, in fact, the best starting point: let’s break them down into something more cogent than: “I want to make money.”

Step 1. Define Your Time-Bound Goals

Everybody has goals: to lose weight, get promoted, become rich. It’s kind of an open secret that those who know exactly what they want to achieve, and by when, tend to make the best plans.

Now, you probably have multiple investing goals. Try to put a dollar value on each of them. Now, divide them into short-term (achievable within 12 months), medium-term (between 1 and 5 years), and long-term (more than 5 years) categories. You’ll probably end up with something like this:

Step 2. Assess Your Risk Tolerance

This exercise can be a real eye-opener. With just a little more work, though, it tells you exactly how to build a portfolio. In particular, your goals determine not just what you hope to gain, but what you can afford to place in less reliable investments. Incidentally, your goals also tell you how much you need to save and invest.

Timeframes dictate risk. If you’ll need $50,000 for a new car, soon, and have $45,000 right now, putting everything in a personal stock portfolio may mean not being able to afford it – bonds may be advisable in this investment portfolio example.

If your focus is on the longer term, you have time to recover from temporary reversals and can take on more risk.

Step 3. Choose an Appropriate Account Type

Your risk profile brings us to the kind of investment account you need. When planning decades ahead, tax implications should be on your mind. In the shorter term, liquidity and safety are greater priorities.

If your employer offers a 401(k) plan, that’s a great place to start. Still, you may also want to look into something like a personalized investment account at a stock broker. The rules governing the various options are tricky, though, so it’s worth spending some time researching these.

If you’re investing for particular goals, a specialized account may be just what you need, especially if you’re concerned about taxes.

Examples include the 529 plan for your kids’ education, an HSA to cover future medical expenses, or a high-yield savings account that allows quick access to some of your funds.

Step 4. Select Financial Assets to Invest In

Referring back to the amount of risk you’re willing to accept in the short, medium, and long term, you now get to decide which kinds of investments suit you best. As a rule of thumb, those that are the most volatile also have the greatest potential upside.

Let’s take a look at some of the most common types:

• Stocks: Considered somewhat risky, the average stock market return is about 10% per year for nearly the last century, as measured by the S&P 500 index.
• Bonds: U.S. Treasuries are considered safer but don’t yield much. However, there are also foreign government bonds and corporate debt to invest in; these are somewhat less solid.
• Investment Funds: Some mutual funds and ETFs invest in a mixture of different types of assets and are, therefore, diversified and relatively stable. Specialized funds and REITs, by contrast, concentrate on particular sectors and can be badly hit by a downturn in those markets.
• Alternative Investments: These run the gamut from gold to complex financial derivatives. The nature of their risk varies accordingly.
• Cash: This doesn’t have to mean stuffing dollar bills into your mattress. Certificates of deposit (CDs), money market funds, and savings accounts are all considered cash: easily accessible and safe.

Step 5. Diversify Your Portfolio

“Don’t look for the needle in the haystack. Just buy the haystack!” – John C. Bogle

Diversification is something you need to pay attention to even if your assets are divided among multiple accounts, or you don’t manage your portfolio yourself. The trick is to spread your investments around several different markets so that any one taking a hit doesn’t affect you too badly.

There are many different ways to segment the global economy into distinct markets, though. You may even believe that your financial portfolio is diversified when nothing could be further from the truth. When you build a portfolio, take the following types of diversification into account:

• Asset classes: Dividing your investments among stocks, bonds, and other types of securities cushions you against most blows.
• Volatility: Using several kinds of investments also reduces your short-term risk – if your stock portfolio becomes wobbly, bonds act as a stable counterweight.
• Industries: What’s bad for one company often benefits another. If you own both airline and petroleum stock, for example, you’re hedged against fluctuations in the oil price.
• Liquidity: It’s always possible that you’ll need cash in a hurry. Should this happen, you’ll be glad to own some assets that can be sold quickly: stocks, CDs, etc.
• Regional: While many investors are satisfied sticking to the U.S., putting some of your money offshore insulates you against trouble with the dollar or American economy.

Step 6. Monitor & Adjust

As you grow older and, hopefully, wealthier, your personalized investment strategy will have to evolve.

In addition, the value and outlook of different assets will change, necessitating a rebalancing of your stock portfolio and other holdings.

A Contrarian View: When the Best Investment Portfolio Isn’t Diversified

All along, we’ve said that diversification is how to build an investment portfolio. 90% of the time, for 90% of the people, this is entirely true. Yet not everyone agrees:

“Wide diversification is only required when investors don’t know what they’re doing.” – Warren Buffett

In other words, if you have both a comprehensive financial background and detailed industry knowledge, you may know how to build a portfolio that’s neither widely diversified nor risky.

This isn’t meant as advice, though: it’s rarely wise to bet against the combined wisdom of thousands of market analysts.

The Bottom Line

While investing only in a single asset class, sector, or even stock is possible, the dangers of doing so are huge. Building a diversified financial portfolio is much safer and should yield adequate returns.

Of course, figuring out the best investment portfolio for your particular needs isn’t always straightforward. There’s no shame in asking for advice, either from a qualified financial planner or even trying a robo-advisor app.

FAQs