Randomly selecting stocks/mutual funds and creating ad-hoc portfolios? Maybe it is time for a change and to do things orderly. Portfolio construction is the process of selecting and allocating assets to create a diversified investment portfolio that meets an investor’s financial goals and risk tolerance. A well-constructed portfolio can help investors achieve their investment objectives while minimizing risk.
In this blog, we will discuss the key principles of portfolio construction and elaborate on how to construct a portfolio that fits your investment needs.
Step 1: Determine your investment objectives and risk tolerance
Before constructing a portfolio, you need to determine your investment objectives and risk tolerance. That is the first step. Your investment objectives should be specific and measurable, such as achieving a certain rate of return, generating income, or preserving capital. For e.g., If you are investing towards a down payment for your dream home then your strategy will be different than when you are in your retirement years and looking to preserve capital. Therefore, it is crucial to first establish the objective.
Risk tolerance refers to the amount of risk you are willing to take on in order to achieve your investment objectives. It’s important to understand your risk tolerance because it can affect the types of assets you choose to include in your portfolio.
Step 2: Choose your asset allocation
Asset allocation is the process of dividing your portfolio among different asset classes, such as domestic stocks, international stocks, bonds, and cash. The goal of asset allocation is to create a diversified portfolio that can potentially maximize returns while minimizing risk.
The optimal asset allocation for your portfolio will depend on your investment objectives and risk tolerance. Generally, younger investors with a longer investment horizon and a higher risk tolerance may have a higher allocation to equities, while older investors with a shorter investment horizon and a lower risk tolerance may have a higher allocation to fixed-income securities.
Step 3: Select your investments
Once you have determined your asset allocation, it’s time to select the investments that will make up your portfolio. It’s important to diversify your investments within each asset class to reduce risk and increase potential returns.
For equities, you can choose to invest in individual stocks, mutual funds, or exchange-traded funds (ETFs). It’s important to consider the company’s financial health, growth prospects, and valuation when selecting individual stocks. Alternatively, mutual funds and ETFs provide instant diversification by investing in a basket of stocks.
For fixed-income securities, you can choose to invest in individual bonds or bond funds. When selecting individual bonds, it’s important to consider the creditworthiness of the issuer, the maturity date, and the yield. Bond funds provide diversification by investing in a portfolio of bonds.
Step 4: Monitor and rebalance your portfolio
Once you have constructed your portfolio, it’s important to monitor it regularly and rebalance it as necessary. Over time, changes in market conditions or individual investments can cause your portfolio to become unbalanced.
Rebalancing involves selling overperforming assets and buying underperforming assets to bring your portfolio back to its original asset allocation. Rebalancing can help you stay on track with your investment objectives and risk tolerance. However, you should be careful to note here that frequent rebalancing can have tax implications for you. Instead, monitor it periodically i.e. every month/quarter and only rebalance your portfolio once the allocation of an asset class moves too far away from its original intended percentage.
For e.g., If you have an overall equity allocation of 80% and due to the bull market that moves to 90% — then you should consider gradually scaling that exposure down to bring it in line with your risk profile and original asset allocation.
You can see an example of how we rebalance our portfolios and the reason why and when we do it.
In conclusion, portfolio construction is an important process for any investor looking to achieve their financial goals. By determining your investment objectives and risk tolerance, choosing your asset allocation, selecting your investments, and monitoring and rebalancing your portfolio, you can construct a portfolio that meets your needs and helps you achieve your investment objectives.
1. What are the steps in portfolio construction?
There are 4 steps in portfolio construction i.e. 1) Determine your investment objectives and risk tolerance 2) Choose your asset allocation 3) Select your investments and 4) Monitor and rebalance periodically.
2. What is the purpose of portfolio construction?
The purpose of portfolio construction is to bring more structure to your investments and invest in a systematic/disciplined rather than investing randomly with no clear direction or purpose. This can help you create a portfolio that is more in sync with your goals and help you reach them on time.
3. Does portfolio construction guarantee returns?
No, constructing your portfolio in a systematic manner does not guarantee returns. However, it is a much better and more manageable way of investing than doing it based on your own whim and instincts.