Building a portfolio: an investment guide

4 Apr 2014 | Guides - Comment now

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Building a portfolio: an investment guide

The right asset allocation is essential to proper portfolio construction

If you're looking to get a better return from your money than you can from a bank account, start here.

An investment portfolio is simply where you keep your money. If all your money is held as cash in your bank account, that’s your portfolio.

But it’s not a smart investment portfolio. The interest you earn on the cash will probably be below the inflation rate, so the value of your money will decrease over time. For example, if your current account offers zero interest and inflation is 2 per cent, every year your money will lose 2 per cent of its value in real terms.

Instead, experts advise that you spread your money around a few different types of investment.


The basics – asset allocation

Note that it should be different types of investment. Putting everything into the stock market, even across a few different company shares, can be as risky as putting everything into the bank account. Similarly, just buying UK government bonds may not be wise.

This is why investment professionals consider 'diversification' to be one of the golden rules of building a portfolio. It means splitting your money across different types of investment – known as asset classes.

Aside from cash, the two asset classes of most interest to investors are equities (stocks and shares) and fixed income (bonds). Both have their advantages and disadvantages.

Based on historical trends going back over a century, you’d expect equities to rise more in value over the long term. After all, equities represent a tiny share in a company. If the company is successful in growing its profits, more investors will want to buy its shares, driving the price upwards.

But they are more risky. If a company does worse than the market expects, your shares can fall dramatically in value. You can limit this risk by investing in massive companies, like supermarkets, banks or utility firms, but even here you can still lose a surprising amount: an investor who put £100 into Royal Bank of Scotland shares in 2007 would, five years later, have been left with less than £10.

Bonds are safer. You buy debt, for example debt issued by a government, and the country pays you back over a set period (hence 'fixed income') so that you get back more than you put in. Governments do, of course, go bust. But it happens very rarely.

The downside with bonds is that you stand to gain less than with equities.

For example, £1,000 invested only in bonds in 1956 would have grown to £56,060 by 2008. But the same amount invested in equities would have left you with £362,740.

But before you put all your money into equities, remember that they’re much riskier than bonds. If you looked at line charts of equity returns and bond returns since 1956, the line on the equities chart would have much bigger swings, up or down, than the bond chart. The measure of how big and how frequent these swings are is called volatility. Equities are much more volatile than bonds. You might get back more than you invested if you wait long enough, but there’s a much bigger chance that when you want to sell, you’ll have to sell at a loss.

So that’s the basic dilemma: slow and steady bonds, or racier and riskier equities. The answer is normally a bit of both, with some cash thrown in for emergencies. But what balance should you strike?


What suits you

The best place to start is with you. Ask yourself why you’re building a portfolio. For most of us, the central task is to build a pot of money that involves you, the investor, taking some risk over the long term, at the end of which ideally you will have built up a sizeable portfolio of diversified assets that will last you through to your twilight years.

Some investors don’t have such a long-term objective and are thus less willing to take on risks. They might for instance only be saving for ten years to cover school fees. Alternatively, they may already be in retirement and need to generate an income while preserving their money against inflation, even at the cost of future opportunity. For both of these latter groups, a sensible investment strategy is likely to involve a relatively low level of ‘risky’ assets such as equities.

So every investor is unique, but everyone faces the same trade-off between risk and reward.

In simple terms, you can’t hope for long-term above-average returns unless you are willing to take on more risk. This might sound like a simple idea but an astonishingly large number of investors persist in the myth that double-digit year-on-year growth is possible without risking the loss of a substantial chunk of their assets.

Talk to any sensible economist and they’ll tell you that investing in equities is only a viable option for the long term, by which they mean at least five years, if not ten.

They’ll also tell you that if capital preservation (avoiding losses) is your primary objective, you should probably steer clear of stocks and shares, and stick to less risky, less exciting assets such as bonds and cash.

If you’re saving for the long term, then put more into equities. But if you’re already retired, favour bonds.


How to diversify

The next key idea is diversification. In the broadest sense, there is one ‘bucket’ of assets in which you might find risky things such as equities, commodities and all manner of alternative investments including commercial property. The other ‘bucket’ consists of less risky assets such as bonds (government or corporate) and cash. Remember that assets in this latter bucket are absolutely not risk free: bonds in particular can rise and fall in price while the value of cash can be eroded by inflation.

These two buckets of ‘assets’ are defined by their risk levels and your job (or that of your adviser) is to match up your personal objectives and tolerances to a mixture of diversified holdings. This might end up looking like a 40/60 blend of low-risk/high-risk assets or any other combination based on your tolerance of risk.

If you are especially risk friendly and have a long time horizon, you might be willing to put 100 per cent of your portfolio into risky assets, whereas if capital preservation is the name of the game, you might stick with 100 per cent low-risk assets.


Growing your assets as you grow

Crucially, you need to understand that as you grow older and your requirements change (as well as your perceptions of risk) your portfolio of assets must also adapt.

To give you an idea of how your portfolio might change, lifecycle or lifestyle funds have been developed. These funds mix equities, bonds and property assets in different proportions according to how close the holders are to retirement (or how far beyond it).

Simply put, they start with 100 per cent of assets in risky equities for a worker in his or her thirties, then end with a portfolio where 75 per cent is allocated to low-risk bonds for an investor into his or her retirement.

This is known in the investment industry as 'lifestyling'. It's a fancy term for a very old rule of thumb: subtract your age from 100 and that's how much you should have in equities. So if you're 30, have 70 per cent of your investment portfolio in equities. If you're 60, have 40 per cent in stocks and shares.


Buy and hold

It is vitally important that any rearrangement of your portfolio is controlled and measured. Never forget that every time you buy and sell assets, some of your money is lost in fees.

Virtually every analysis of historical returns suggests that investors shouldn’t over-trade, shouldn’t try to time the markets, and absolutely should avoid turning into speculators.

Instead, the consensus is that private investors should work out a long-term strategy, build a diversified, robust portfolio and then sit tight as a buy-and-hold investor.

Research shows that the most active traders (averaging over 250 per cent portfolio turnover annually) earned 7 per cent less per year than buy-and-hold investors, who averaged just 2 per cent portfolio turnover.

It’s simple. Every time you trade and change your asset allocations based on a hunch, you’ll incur transaction and advisory charges.

Say you have a £50,000 savings pot and achieve an annual investment return of 8 per cent per annum. An extra 1 per cent per annum in trading charges results in a reduction in returns over 30 years of more than £100,000 – twice the present value of the portfolio.

There is a world of difference between being an investor – buying assets and sticking with them for the long term – and being a trader – trying to profit from short-term price movements. The former strategy is endorsed by the world's most famous and successful money managers, from Warren Buffett and Benjamin Graham in the US to Neil Woodford and Anthony Bolton in the UK.


Portfolios: the bottom line

The basics of building an investment portfolio are surprisingly simple. Work out your own investing style and then make sure that your diversified mixture of asset classes mirrors your own risk-reward trade off.

If you’re willing to embrace higher risk levels and won’t need the money for a while, think about tilting your portfolio towards shares. If you only have a narrow time horizon for what you want to achieve from your investment, give more weight to bonds and cash.

And don’t get too carried away: keep the underlying funds within your portfolio simple and cheap, and don’t over-trade.

Guide originally published: 16/8/12. Updated: 4/4/14.


Related investment guides

Building an ISA portfolio – save tax by investing through an ISA

Large, mid and small caps – get the right mix in your portfolio

Open-ended funds – invest in equities or bonds through a diversified fund

Bonds – find out more about fixed income

Online share dealing – find out how to trade shares cost-effectively online

Related topics: Asset allocation, Bond funds, Bonds, Diversification, Equities, Gilts, Inflation, Investment trusts, Open-ended funds, Pensions

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