Financial Portfolio: What It Is, and How to Create and Manage One
What Is a Financial Portfolio?
A portfolio is a collection of financial investments like stocks, bonds, commodities, cash, and cash equivalents, including closed-end funds and exchange traded funds (ETFs). People generally believe that stocks, bonds, and cash comprise the core of a portfolio. Though this is often the case, it does not need to be the rule. A portfolio may contain a wide range of assets including real estate, art, and private investments.
You may choose to hold and manage your portfolio yourself, or you may allow a money manager, financial advisor, or another finance professional to manage your portfolio.
KEY TAKEAWAYS
- A portfolio is a collection of financial investments like stocks, bonds, commodities, cash, and cash equivalents, as well as their fund counterparts.
- Stocks and bonds are generally considered a portfolio’s core building blocks, though you may grow a portfolio with many different types of assets—including real estate, gold, paintings, and other art collectibles.
- Diversification is a key concept in portfolio management.
- A person’s tolerance for risk, investment objectives, and time horizon are all critical factors when assembling and adjusting an investment portfolio.
- Portfolio management is an important financial skill for active investing.
Understanding Financial Portfolios
One of the key concepts in portfolio management is the wisdom of diversification—which simply means not putting all of your eggs in one basket. Diversification tries to reduce risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event. There are many ways to diversify.
How you choose to do it is up to you. Your goals for the future, your appetite for risk, and your personality are all factors in deciding how to build your portfolio.
Regardless of your portfolio’s asset mix, all portfolios should contain some degree of diversification, and reflect the investor’s tolerance for risk, return objectives, time horizon, and other pertinent constraints, including tax position, liquidity needs, legal situations, and unique circumstances.
The word “portfolio” comes from the Latin folium, meaning to “carry leaves” (as in papers). Stock and bond certificates were once only issued in paper form, from which this terminology was adopted. Portfolio is also used to describe an artist’s collection of works, for similar reasoning.
Managing a Portfolio
You may think of an investment portfolio as a pie that’s been divided into pieces of varying wedge-shaped sizes, each piece representing a different asset class and/or type of investment. Investors aim to construct a well-diversified portfolio to achieve a risk-return portfolio allocation that is appropriate for their level of risk tolerance. Although stocks, bonds, and cash are generally viewed as a portfolio’s core building blocks, you may grow a portfolio with many different types of assets—including real estate, gold stocks, various types of bonds, paintings, and other art collectibles.
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The sample portfolio allocation pictured above is for an investor with a low tolerance for risk. In general, a conservative strategy tries to protect a portfolio’s value by investing in lower-risk securities. In the example, you’ll see that a full 50% is allocated to bonds, which might contain high-grade corporates and government bonds, including municipals (munis).
The 20% stock allocation could comprise blue-chip or large-cap equities, and 30% of short-term investments might include cash, certificates of deposit (CDs), and high-yield savings accounts.
Most investment professionals agree that, though it does not guarantee against loss, diversification is a key component for reaching long-range financial goals while minimizing risk.
Types of Portfolios
There can be as many different types of portfolios and portfolio strategies as there are investors and money managers. You also may choose to have multiple portfolios, whose contents could reflect a different strategy or investment scenario, structured for a different need.
A Hybrid Portfolio
The hybrid portfolio approach diversifies across asset classes. Building a hybrid portfolio requires taking positions in stocks as well as bonds, commodities, real estate, and even art. Generally, a hybrid portfolio entails relatively fixed proportions of stocks, bonds, and alternative investments. This is beneficial, because historically, stocks, bonds, and alternatives have exhibited less than perfect correlations with one another.
A Portfolio Investment
When you use a portfolio for investment purposes, you expect that the stock, bond, or another financial asset will earn a return or grow in value over time, or both. A portfolio investment may be either strategic—where you buy financial assets with the intention of holding onto those assets for a long time; or tactical—where you actively buy and sell the asset hoping to achieve short-term gains.
An Aggressive, Equities-Focused Portfolio
The underlying assets in an aggressive portfolio generally would assume great risks in search of great returns. Aggressive investors seek out companies that are in the early stages of their growth and have a unique value proposition. Most of them are not yet common household names.
A Defensive, Equities-Focused Portfolio
A portfolio that is defensive would tend to focus on consumer staples that are impervious to downturns. Defensive stocks do well in bad times as well as in good times. No matter how bad the economy is at a given time, companies that make products that are essential to everyday life will survive.
An Income-Focused, Equities Portfolio
This type of portfolio makes money from dividend-paying stocks or other types of distributions to stakeholders. Some of the stocks in the income portfolio could also fit in the defensive portfolio, but here they are selected primarily for their high yields. An income portfolio should generate positive cash flow. Real estate investment trusts (REITs) are examples of income-producing investments.
A Speculative, Equities-Focused Portfolio
A speculative portfolio is best for investors that have a high level of tolerance for risk. Speculative plays could include initial public offerings (IPOs) or stocks that are rumored to be takeover targets. Technology or healthcare firms in the process of developing a single breakthrough product also would fall into this category.
Impact of Risk Tolerance on Portfolio Allocations
Although a financial advisor can create a generic portfolio model for an individual, an investor’s risk tolerance should significantly reflect the portfolio’s content.
In contrast, a risk-tolerant investor might add some small-cap growth stocks to an aggressive, large-cap growth stock position, assume some high-yield bond exposure, and look to real estate, international, and alternative investment opportunities for their portfolio. In general, an investor should minimize exposure to securities or asset classes whose volatility makes them uncomfortable.
Time Horizon and Portfolio Allocation
Similar to risk tolerance, investors should consider how long they have to invest when building a portfolio. In general, investors should be moving toward a conservative asset allocation as their goal date approaches, to protect the portfolio’s earnings up to that point.
For example, a conservative investor might favor a portfolio with large-cap value stocks, broad-based market index funds, investment-grade bonds, and a position in liquid, high-grade cash equivalents.
Take, for example, an investor saving for retirement who’s planning to leave the workforce in five years. Even if that investor is comfortable investing in stocks and riskier securities, they might want to invest a larger portion of the portfolio in more conservative assets such as bonds and cash, to help protect what has already been saved. Conversely, an individual just entering the workforce may want to invest their entire portfolio in stocks, as they may have decades to invest, and the ability to ride out some of the market’s short-term volatility.
How Do You Create a Financial Portfolio?
Building an investment portfolio requires more effort than the passive, index investing approach. First, you need to identify your goals, risk tolerance, and time horizon. Then, research and select stocks or other investments that fit within those parameters. Regular monitoring and updating is often required, along with entry and exit points for each position. Rebalancing requires selling some holdings and buying more of others so that most of the time your portfolio’s asset allocation matches your strategy, risk tolerance, and desired level of returns. Despite the extra effort required, defining and building a portfolio can increase your investing confidence and give you control over your finances.
What Does a Good Portfolio Look Like?
A good portfolio will depend on your investment style, goals, risk tolerance, and time horizon. Generally speaking, a good degree of diversification is recommended regardless of the portfolio type in order to not hold all of your eggs in one basket.
How Do You Measure a Portfolio’s Risk?
A portfolio’s standard deviation of returns (or variance) is often used as a proxy of overall portfolio risk. The standard deviation calculation is not merely a weighted average of the individual assets’ standard deviations – it must also account for the covariance among the different holdings. For a 2-asset portfolio, the standard deviation calculation is:
σp= (w12σ12 + w22σ22 + 2w1w2Cov1,2)1/2
The Bottom Line
A portfolio is a cornerstone of investing in the markets. A portfolio is comprised of the various positions in stocks, bonds, and other assets held, and is viewed as one cohesive unit. The portfolio components, therefore, must work together to serve the investor’s financial goals, constrained by their risk tolerance and time horizon. Portfolios can be constructed to achieve various strategies, from index replication to income generation to capital preservation. Regardless of the strategy, diversification is seen as a good way to reduce risk without sacrificing the portfolio’s expected return.
Financial Portfolio
A financial portfolio is a collection of investments held by an individual, organization, or entity. The goal of a portfolio is typically to achieve a balance between risk and potential returns, based on the investor’s objectives, risk tolerance, and time horizon.
Here are some key points to consider when creating and managing a financial portfolio:
- Diversification: Diversifying your portfolio involves spreading your investments across different asset classes, industries, and geographic regions. This helps reduce the risk associated with the poor performance of a single investment.
- Asset Allocation: Decide on the proportion of your portfolio to allocate to various asset classes such as stocks, bonds, real estate, and cash. The allocation should align with your financial goals and risk tolerance.
- Risk Tolerance: Understand your risk tolerance, which is your ability and willingness to withstand fluctuations in the value of your investments. This will guide your investment decisions.
- Investment Types:
- Stocks: Represent ownership in a company and offer the potential for capital appreciation.
- Bonds: Debt securities issued by governments or corporations. They provide regular interest payments and return of principal at maturity.
- Mutual Funds and Exchange-Traded Funds (ETFs): These funds pool money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other assets.
- Real Estate: Investments in properties, either directly or through real estate investment trusts (REITs).
- Cash and Cash Equivalents: These are low-risk, highly liquid assets like savings accounts, certificates of deposit, and money market funds.
- Investment Goals:
- Short-Term Goals: Investments for expenses within the next 1-3 years, such as buying a car or going on a vacation.
- Medium-Term Goals: Investments for goals within 3-10 years, like buying a home or funding education.
- Long-Term Goals: Investments for retirement or other objectives that are more than 10 years away.
- Monitoring and Rebalancing: Regularly review your portfolio’s performance and adjust your allocations if they deviate from your desired targets. Rebalancing helps maintain your desired risk and return profile.
- Risk Management: Consider how much risk you’re comfortable with, and choose investments that align with that risk level. Keep in mind that higher potential returns often come with higher levels of risk.
- Tax Efficiency: Be mindful of tax implications. Different investment types are taxed differently, and strategic tax planning can help you minimize your tax burden.
- Professional Advice: If you’re unsure about creating or managing a portfolio, consider consulting a financial advisor who can help you align your investments with your financial goals.
Remember that building and managing a portfolio is an ongoing process that should be adjusted as your financial situation and goals change. It’s important to conduct thorough research and consider seeking advice from financial professionals before making any investment decisions.