Investing 101 Part 3

Photo by Tax Credits

Alright, so far we have looked at why you should be investing and some of the things you can invest in. Now it's time to look at actually building a portfolio.

Maybe we should back up a step and define "portfolio" . A portfolio is the term used to refer to all of your investments. Think of it sort of like a grocery cart. You fill it full of a variety of different items in order to satisfy your need for food. Some people like to play it conservative, milk, eggs, juice, bread, etc. While others like being a little more risky and throw in a bag of black bean BBQ chips every now and then. It's the same thing with a portfolio. You fill it up with whatever fits your style, in order to satisfy your need to increase your wealth.

Risk Tolerance

That's a good place to start, what is your style? Do you enjoy taking a little more risk if there is the potential for more rewards? Or are you more of a slow and steady wins the race kind of person? This is one of the main factors in determining the makeup of your portfolio.

Another main factor is your timeframe. How soon will the money being invested need to be accessed? The portfolio of someone who is investing money that isn't needed for 30 or more years down the road is going to be a lot different than someone who may need their money in the next 5 years.

The reason those portfolios should be different has to do with volatility, the potential for large changes in an investments value, and the stock market has plenty of that. See, if you're investing in the stock market for the short-term, then a market crash like 2000 or 2008 could quickly cut your portfolio's value in half. With only a few years to recover, you could have to sell your investments before they have the chance to recuperate. However, with a 30 year timeframe, you may hit a few crashes but over the long haul those are mere bumps in the road. The investments have time to recover from market crashes or lulls before you are pressured to sell them.

By combining these two factors, timeframe and style, you can get an idea of how comfortable you are with risk. Since this is Investing 101, I'll keep it pretty basic. The more risk you want, the higher the percentage of stocks you should have in your portfolio. If you want less risk, then increase your percentage of bonds. Fair enough.

Now let's say that you like risk and you're investing for a long time frame. You'd reason that you want most if not all of your portfolio in stocks. So since you're a car guy (fist bump) you think you'll put all your portfolio in Ford, GM, and VW. Well, not so fast.

Diversification

There's one more thing to consider when building a portfolio and that's diversification. Let's say you put all that money in those three car companies. Then tomorrow teleportation is invented and now cars have become much less important. Now your awesome motorhead portfolio is worthless. Basically, don't count your chickens...wait wrong farm phrase, oh yeah, don't put all your eggs in one basket.

The easiest way to get diversification? Buy a total market index mutual fund. This gives you a little piece of many different companies. You can also throw in a total international index fund and a bond index fund too. Then you're diversified across countries and asset classes as well. Diversification can also be achieved by purchasing a large number of different individual stocks and bonds. However, that can be a pretty time-consuming task. These three mutual fund selections make it a lot easier to achieve a simple diversified portfolio.

Asset Allocation

Now it's time to put all that together and create your ideal portfolio. To do that you need to figure out what your asset allocation will be. Asset allocation is just a fancy way of saying what percentage of your money is in stocks, bonds, etc.

This is where risk tolerance comes in to play. If you're investing money that is needed within five years, stick with bonds. For anything greater than that, the stock market is an option. It's a good rule of thumb to keep your percentage of bonds equal to your age if investing for the long haul. Since I'm 27, I'd have 73% stocks and 27% bonds. That makes it nice and easy. Although I actually have a lot more in stocks because I'm comfortable with the risk.

What's your risk tolerance? Are you the slow and steady type or do you prefer high risk/high reward?