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The Basics of Constructing an Investment Portfolio

Investors are often advised to build an investment portfolio. However, many may still think that constructing a portfolio is something complicated and only necessary for the rich. In simple terms, an investment portfolio is a collection of assets of an individual. Every one of us has been building our own investment portfolios without realizing that we are doing so when we decide to make investments. However, we may not be doing it in a systematic and effective way, more often than not, we pick our investments based on tips and gut feelings, following the tide rather than considering whether the investment fits into our own investment circumstances.

 

Before we even start to think about what to invest, there are two major considerations. First, we should list down clearly what we own and what we owe, in other words, create a balance sheet of our own financial status. From there, we determine how much money that is available for investment and how much monthly contribution  we are able to put into the investment pool after taking into considerations our routine commitments.

 

Next, ask ourselves a very crucial question, ‘why are we investing?’ Whether it is for the purpose of retirement or children’s education fund or simply to fulfil a short-term need will lead to entirely different portfolio mix and investment outcomes. From the investment purpose, we can then derive how much money  is required to fulfil our investment goal and how much time  we have to achieve our goal. In financial terms, this is the investment horizon for the investor. Now that we know how much that is required and when we need the money, we are ready for the next step - deciding how to allocate our money in various investments, this is what we call asset allocation.

 


There are three common asset categories, namely cash, stocks and bonds, each having different risk and return profiles. Among these three categories, cash is the most liquid and lowest risk of all, which also means it has the lowest return, usually at the risk-free rate. However, we must still allocate part of our money here.As a rule of thumb, we should always keep a sum amounting to about six months of our expenses in the cash pool.This is a preventive measure to ensure that in case of emergencies, there is cash available for us to meet our immediate needs, without having to liquidate other investments that may not be in the best position to be disposed of at that point in time.

 

Stocks investing is what most of us are familiar with, but that does not mean that all of us are able to make a return out of it. Usually, stocks investments are good for growing our principal and offsetting inflation rates. However, within itself, there are many different types of stocks. For example, investments in growth stocks may be suitable for an investor who is investing for his children’s education which may be due in more than a ten-year period but not for a retired investor, who may be more suitable to invest in income stocks that provide dividend income. On the other hand, bonds are known to be a debt instrument that is commonly used to generate consistent stream of income, while offsetting the stock market risks.

 

The key consideration in the asset allocation process is mainly to strike a balance in between the returns that we get and the risks that are inherent in the investments. As nobody will know exactly when the market is going to peak or tip over, by diversifying our investments in different buckets, especially those that are moving in different directions or having low correlations, such as stocks and bonds, we are in effect reducing the risks of our investments. In investments, we must always remember that no matter how good a company is, we should never put all our money in one company or even a few companies that are in the same industry.

 

Some of us may have only limited funds for investments. But this does not stop us from diversifying our investments. We can still achieve a well-balanced portfolio through investments in mutual funds. Of course, this comes with a price as we need to pay for the management fees of the fund managers who help to manage the funds. To further reduce the risk of our investment, we can choose to invest in funds with different investment styles and investment objectives.

 

Once we have our investment portfolio built-up, the process does not stop there. As we go through different stages of our lives, our investment purposes and investment horizons will change and we must rebalance our portfolio accordingly.

 



 
Ooi Kok Hwa
CFA, CM & AA, MA (Finance), B.Sc (Actuarial Science)
Managing Partner of MRR Consulting