When was the last time you reviewed your Investment Portfolio and risk tolerance? Do you need to be licensed or an expert to create one?
Have you even started out one yet?
Well, if you haven’t yet or are just planning on creating one, then this post is for you.
Financial terms such as Investment portfolio, diversification, asset allocation, risk tolerance are just some words that are frequently used in the world of finance.
It would be great if you will have some idea of its definition and how you can apply it in your life whether you have no investments at all or are just starting out.
This post will give you a simple overview and a newbie’s guide to creating an Investment Portfolio.
Basically there are 3 steps in creating your Investment Portfolio:
1. Asset Allocation
2. Diversification
3. Rebalancing
This post has 2 series namely:
Part 1. Asset Allocation
Part 2. Diversifying your assets and how to Rebalance them to keep track with your financial goals.
So if you are done with reading this post which is Part 1, you may click here for : Part 2 Diversification and Rebalacing
First, let’s dig deeper by starting with the definition of a few terms. It is a must to familiarize yourself with these:
Personal finance is simply the management of your money and financial decisions including budgeting, investments, retirement planning and the like.
Other components might include checking and savings accounts, credit cards and consumer loans, investments in the stock market, SSS Benefits, insurance, basically everything within the scope of your finances.
Please do remember that from the word itself, PERSONAL FINANCE is a personal endeavor-you are the one who can decide how to handle your money, not anyone else.
Why is personal finance important?
Simple. It helps you determine your short term and long term financial goals while creating a balanced plan to meet these goals. One example is providing for your family’s financial security which I’m sure is part of your goals.
What is Asset Allocation?
Asset Allocation (which is what this post is all about) involves dividing your investment portfolio among different asset categories such as bonds, stocks, and cash. Then again, the process of deciding which mix of assets to use is a personal one and totally depends on you.
Once you determine how your assets are allocated, you are now ready to Diversify.
We’ll discuss more about Asset Allocation later on as this is the first step.
What is Diversification?
Diversification enables you to reduce the risks of your portfolio without sacrificing your potential returns. This is done through investing in different types of asset to reduce your risk.
Once your portfolio has been diversified, you are now able to take on additional risk to earn a higher potential return on your portfolio.
This is one of the important ways to lessen the risks of investing. As the famous saying goes, never put all your eggs in one basket.
“Do not put all your eggs in one basket” – Warren Buffett
Why should you not put all your money in one investment option?
If you put all your money in one investment and it went down in value, then it can wipe out all your hard earned money and you may lose it all. Losing all your money can haunt you for years and will make you rethink of wanting to step into the world of investing again.
But if you placed your money in 5 different investments and one went down in value, then you could still come out ahead and enjoy the gains of the other 4.
The relation between risks and returns
This is something not a lot of people understand or take into consideration when investing so let me explain this as simple as possible.
It is important for you to understand the relation between risks (losing money) and returns (potential gains) because this will help you determine what type of investments will suit you better which will be tackled on later.
Generally speaking, risks and return are DIRECTLY RELATED, meaning as the risk level of an investment increases, the potential return increases as well.
If the risk level is low, the potential returns are low too. Furthermore, the greater the risk of loss, the higher the returns.
One example is your savings account.
Savings accounts are considered low risk investments because the risk level of losing your money is very slim to none. Why? Because your money is backed up by the bank which is a large financial institution. In the unlikely event that the bank closes, it is still insured by the PDIC (Philippine Depository Insurance Corporation). Hence, savings accounts carry low risks, making it very unlikely for you to lose money.
But on the other hand, savings accounts have a lower potential return. Notice how little interest rates are? The percentage is so small, it really cannot keep up with today’s inflation.
See how the risk level and returns are related? Here’s another example.
The stock market, as we all know, is very volatile. It is an emotional platform. They say you can lose a lot of money especially if you are not familiar with the fundamental and technical analysis. Thus, making it a high risk investment.
But despite carrying high risks, it also entails a higher potential return. The stock market is very lucrative and has made millionaires. Your potential gains increase as you see the share price rising and higher dividends being paid by companies.
This is one good example of how your potential returns increase when you choose a riskier investment.
Generally, the higher the potential return of an investment, the higher the risk.
But still, there is NO GUARANTEE that you will actually get a higher return by accepting more risk.
Now you know how they are related, here is a list of investments you can choose from according to their level of risks:
Low risk investments
*Cash deposits, Savings account, Time deposits
*UITFs and Mutual Funds (Money Market Funds, Bond Funds)
*Bonds (Retail Treasury Bonds and corporate bonds)
*Investments in insurance (VUL, healthcare)
*Small businesses (online and home-based business)
Medium risk Investments
*Multi-level marketing business
*UITFs and Mutual Funds (Balanced Funds, Index Funds)
*Medium scale businesses
High risk Investments
*UITFs and Mutual Funds (Equity Funds)
*Stock Market
*Forex Trading
*Real estate
*Big scale businesses (corporations, big franchises)
Step 1. Creating your Asset Allocation plan
An asset allocation plan depends on your risk appetite. The younger you are, the better you can take higher risks.
There are 2 ways on how you can allocate your assets.
1. “100 minus your age” Formula
Most people use the “100 minus your age” formula with the answer equivalent to the percentage allocated to high risk investments and the rest allocated to much safer investments such as medium risk and low risk investments.
For example. If you are 27 years old then 73 % should be allocated to equities such as stocks and 27% to bonds or mutual funds
Some use the 50-50 rule. When the market is bullish, some use the 75-25 Rule and when it’s bearish, 25-75. There are some young investors that are so aggressive who have placed 100% in equities, they are in for the long haul. To each his own.
2. According to your investment personality
You can determine the asset allocation that best suits you based on your investment personality
a. Conservative Personality
This entails a very low risk and very low rate of return portfolio and is best for people who are older or are near retirement age. Since you are nearing retirement, your goal is to preserve your money or principal (the amount you initially invested) instead of making it grow by risking it in high risk investments.
20% Equities
70% Bonds
10% Cash
Notice that a large percentage is reserved for Bonds which are low risk investments.
b. Moderate Personality
This portfolio is best designed for investors who have a medium risk tolerance and have an investment horizon of more than 5 years. This usually entails a balance between high risk investments and low risk investments.
50% Equities
35% Bonds
15% Cash
c.Aggressive Personality
This best suited for the young ones who have plenty of years to make their investments grow over a long term horizon. Think about those in their early 20’s and 30’s who won’t be needing the money soon hence, can tolerate market fluctuations and downtrends.
80% Equities
10%Bonds
10%Cash
Final Words
The 100 age formula and the investment personality options are just suggestions.
Do remember that the closer you are to your financial objectives, the less aggressive you need to be, and start moving your investments to less riskier investments.
Once again, personal finance is a personal preference and will depend on what works best for you at any given point in your life.
Whatever formula you use, make sure it suits your risk appetite and goals.
Click here to go to Part 2 Diversification & Rebalancing
Disclaimer: The investing tips in this blog do NOT constitute as professional financial advice. These are based on experience and personal knowledge. Consult with a certified adviser to address your specific financial concerns.