Investing for Beginners – How to Construct your Optimal Portfolio

Now that you have opened up your first brokerage account, we have reached that point in our investing journey where we can start learning how to create a portfolio. Now before we start chatting about stocks, bonds, the stock market and any other financial terms that are thrown around on TV, we should first define what a portfolio is and what needs to be considered when creating the optimal portfolio for you. 

Please note that there is no single optimal portfolio, every single person will have a slightly different portfolio type that is based on your current financial situation and on specific attributes that are unique to you such as age and time horizon for investing. To highlight this, think about the time horizon and the financial stability of a recent university graduate – they have plenty of time for compounding their money but not a lot of disposable income to begin investing as they just finished school. Compared to a person who has been working the last 40+ years and is preparing to retire, they have plenty of disposable income but a short time horizon for investing their hard-earned money. So what is a portfolio? A portfolio is a simple financial term that encompasses all types of investments that are held by an individual. In most portfolios, this can include any, but not limited to, the following: stocks, bonds, mutual funds, ETFs, savings account, options, Real Estate and Cryptocurrency. 

The first thing that we need to consider when we start creating a portfolio specific to you is to consider your needs and what your goals are for this portfolio. Someone who is looking to save money for retirement will construct a very different portfolio than someone who just wants to invest and build-up enough money to put as a down payment for a house in a 3-5 year period. Your portfolio must also take into account your ability to take risks: higher risks means the potential for higher returns but with the downside of losing more money. The more risk that you potentially take; the more aggressive you are expected to be in terms of your investments. What we mean by this is that, for those willing to take higher risks, they would invest more in stocks with a lower value in bonds compared to those who are risk-averse that might increase their value in bonds rather than in stocks to minimize the amount of money they could potentially lose.

Three General Types of Portfolios

So what does an aggressive risk-taking portfolio look like? Usually, when people choose an aggressive portfolio, they are looking for high returns in a shorter period of time. They tend to have portfolios that are 90% stocks and about 5% bonds and cash, respectively. You keep 5% in cash just in case there is a buying opportunity in the near future. No matter what, it is always important to make sure that the stocks that are chosen are strong companies and not penny stocks or stocks that you are simply hoping will rise quickly so that you can make a profit. People who take an aggressive portfolio can expect very large daily fluctuations in their accounts.

On the other side of the spectrum, you can also choose a conservative portfolio that is geared towards people who prefer to take less risk but have a higher likelihood of not losing their initial capital. The main idea of a conservative portfolio is to retain its value and help protect the investor from any potential losses while having the opportunity for an upside. People who take a conservative portfolio can expect very small daily fluctuations in their accounts. This type of portfolio would be made up of 60% bonds or fixed income, 30% stocks and 10% cash to provide liquidity when purchasing during market dips.

There is also a third portfolio type that falls in between the two extremes: The balanced portfolio. The balanced portfolio is geared towards people who prefer to have some risk in the market but with the protection that fixed income provides. People who take a balanced portfolio can expect smaller daily fluctuations in their accounts. This type of portfolio would be made up of 40% bonds or fixed income, 50% stocks and 10% cash to provide liquidity if they wish to rebalance their portfolio periodically.

Changes to your Portfolio

Once you have taken the time to decide which type of portfolio is best for you, it is important to keep assessing it every 3 months – quarterly – as changes in the market can distort and change the percentages of each option in your portfolio. As an example, let us say that you have decided to choose an aggressive portfolio – made up of 90% stock and 10% bonds – and you invested $10,000 in total. Right when you invest your money, you currently have $9,000 in stocks and $1,000 in bonds. Let us say that during your first quarter, the stock market is in a bull cycle (meaning that stocks increase and bonds decrease) and you are left with the following changes: stocks increased from $9,000 to $11,000 and bonds decreased from $1,000 to $500. So now, your total portfolio worth is $11,500, an increase of 11.5%! Now you might be celebrating because that is quite a large increase in such a small amount of time but if we look at the numbers, you will now realize that your portfolio no longer fits your 90-10 split. Instead, with the large increase in your portfolio, stocks make up 95.65% and bonds make up only 4.35%, which means that you currently hold a hyper-aggressive portfolio. This has occurred because of the change in value of specific asset classes in your portfolio as stocks went up and bonds went down. This is why it is important to keep assessing your portfolio and make changes every quarter so that you avoid having too much money in a specific asset class than you would prefer. Also, note that the same situation occurs for specific industries – think energy, technology or even real estate – if one industry does extremely well compared to the others, it will begin to take up a larger portion of your portfolio and could lead to trouble down the road if this specific industry were to dip quickly. This is why most financially literate individuals believe that 3 months is a good amount of time to rebalance your portfolio as any shorter would cause you to pay high commission/trading fees in your brokerage account. 

There are also situations where your preferences could change. If you are a young graduate who only has $500 to invest your first year, as you begin making more money, you might feel more comfortable taking more and more risk as you have enough money on the side-lines to live comfortably and all of your extra income is going directly to investing. This is another case where you would normally reassess your portfolio composition to determine what works best for you. 

Usually, when you are younger and have more time to invest, most young individuals will build an aggressive portfolio to try and maximize their gains as any major drawbacks can be resolved over years in the market. As you get older and have more responsibilities (kids and/or a mortgage), you are not as comfortable losing big sums of money in the hopes of making a higher return and you tend to move towards a more balanced or conservative portfolio. When taking the time to construct and rebalance your portfolio over the following months and years, always remember that diversifying your portfolio is a key to success. This allows your portfolio to weather any storms, as it will not rely on a particular industry that could disappear or begin doing very badly. A well-diversified portfolio is a lot more sustainable over a long term horizon and helps avoid any unforeseen changes in the economy – or at least tries its best to avoid the fallout of a bad market situation (think pandemic). At the end of the day, it is important to figure out what type of portfolio will help you sleep at night as the stress of seeing your investments go down will lead you to make bad financial decisions. The whole point of creating an optimal portfolio for you is to avoid any stress, just let your portfolio work for you and enjoy the rewards that will come with time!

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