Investment portfolios, risk, return, assets and liabilities. We often hear these terms when any financial topic comes under debate. But, what does any of that actually mean? What is an investment portfolio?
Before delving deeper into any financial terminology, we must first understand investment.
Why do people invest and how do they go about it? In simple terms, investing is the process of spending resources in return for expected future profits. Even more simply put, investment is making your money “work for you”.
What is an Investment?
A more technical definition would refer to investment as a commitment of resources for a period of time in order to derive future profits that would compensate the initial spending of money and time, the risk investors take and the rate of expected inflation.
There are many ways to invest and even more types of investments. People nowadays invest in stock, real estate, bonds, crypto currency, and other financial products.
The upfront money given in the form of capital, investment or seed money is perceived as a loan. An investor will only put their resources on the line if the generated income or return is seen as worthwhile.
The profits generated from initial investments are often referred to as ROI or return on investment. These returns take the form of dividends in stocks, coupons in bonds or interest in loans.
Return however, is not the only thing to consider when making investments. The volatility or the perceived level of risk involved in each investment opportunity is what ultimately decides the attractiveness of any financial venture.
People usually invest for one simple reason; foregoing a percentage of their consumption today in return for bigger profits tomorrow guarantees the flow of money continuously in the future if done right.
The Nature of Investment Portfolios
The nature of the market worldwide is mostly dependent on the free cash flow activities, meaning that money is always circulating in the market. A viable investment is one that has good return relative to the initial investment and relative to its perceived risk.
There are many ways to invest and many types of different investments that can be included in your portfolio.
Ownership investments typically include buying undervalued assets while selling overvalued ones. In other words, buy cheap and sell high. Investors can own stocks, real estate or even whole businesses.
The investor then chooses at a later time to sell their holdings for a price higher than what was initially paid, generating revenue.
A bond is basically a loan to a company that will be paid back to the bond holder with interest.
Companies issue bonds to borrow money at an interest rate less than that of a bank, while rewarding the bond holder with interest more than they would typically get from interest generated from bank saving accounts.
Aside from bonds, there are other types of lending activities that include options, government or federal certificates and your typical bank savings account.
Other unclassified types of investment which do not fall under the 2 categories listed above would include investing in foreign currency exchange (FOREX), Debt purchasing or taking advantage of short term price fluctuations such as those seen in gold.
These strategies have a very short investment horizon, so they are often referred to as day trading.
However, these alternative investment methods are better off left to the pros. This is because they require experience and a deeper knowledge in the mechanism of finance and more familiarity with global micro and macroeconomics.
Investment Portfolios: Scratching the Surface
Getting to the real investment portfolio definition is not simple. It means something different for everyone. The term “portfolio” is thrown around in a lot of different workplaces.
A writer has a portfolio of his/her writings. Artists have portfolios that include their paintings or drawing, even architects have design portfolios with their earlier work and sketches. However an investor’s portfolio is something entirely different.
A financial portfolio is the sum of your assets or investments, along with your liabilities.
The portfolio of an investor would look a lot like the pizza you would order on a lazy Sunday afternoon. It’s divided into slices, where each slice represents a portion of the investor’s financial holdings.
These holdings can be large cap growth stocks, high yield bonds, cash equivalents or assets.
The portfolio as a whole is given a certain risk and return rating. The risk given to a complete portfolio is calculated by factoring in the risk of each individual investment inside the portfolio.
Your average investor would likely try to keep return as high as possible while retaining a low risk rating. Most investors are categorized as risk-averse; meaning that they would prefer to avoid or lower risk as much as possible even if it means decreasing the expected return.
After making the portfolio definition clear we must mention the famous economist “Harry M. Markowitz” who provided a theory called “The Modern Portfolio Theory” (MPT for short).
This theory bases a few assumptions on how investors choose to structure their portfolios.
The two main concepts of the modern portfolio theory is that most investors will do what they can to maximise return while minimising risk. The second concept is that risk can be minimised by utilising a well-diversified portfolio.
Diversify? Why Not Just Pick a Winner?
Now that the portfolio definition is clear we can talk about portfolio diversification. You might have heard of the term “diversification” before, but what exactly is portfolio diversification?
Reducing risk while retaining the same level of return? Ludicrous, you might say. High return equals high risk.
Not necessarily. A well-diversified portfolio could effectively reduce your risk rating while retaining or even maximizing your returns.
Think of it like this, you have twelve eggs and you need to transport them from point A to point B. Sure, you can pile them all in the same basket. Along comes a friend with an extra basket. You think to yourself, maybe two light baskets would be easier than one heavy one.
On route, one of the baskets gets torn up and you lose six of your eggs. It’s a loss, sure. But at least you didn’t lose all twelve. “Don’t put all your eggs In one basket” is a phrase that perfectly describes the need for portfolio diversification.
Any industry’s fate can overturn overnight for many reasons. Shortage of supplies, decrease in price of alternatives, governmental restrictions or even political forces.
For example, a group of people decide to diversify their portfolio, they use their investment to buy stocks in five different automotive companies. When one of those companies falls short, the others are bound to rise.
This type of diversification makes the portfolio holder somehow protected. However, let’s say that economic conditions lead to fuel costs going dramatically up. Suddenly, driving seems too expensive.
A well-diversified portfolio will include investments that are not correlated, meaning that each individual investment inside the portfolio is either inversely or disproportional to one another.
So if one goes down in value, the others will balance out this loss.
Investing in different companies, diverse industries and even different countries is the best way to have a well-diversified portfolio. Diversification however does not eliminate risk, it only reduces it.
The Road To Building Your First Portfolio
Most investors are risk averse, meaning that they prefer to reduce risk even if return is minimised along with it. However, no two portfolios are the same. How do you allocate your resources?
Do you go for high risk/high return? Do you play it safe and settle for less profit? Building a portfolio can be a daunting process given the many variables in play. First and most important step is to understand why you want to invest in the first place?
Are you saving for a long term goal? Are you willing to take risks? If so, how much risk is too much? All these are questions you should be asking yourself before engaging in any investment activities.
From afar, building a portfolio sounds simple; just buy different stocks, invest in startup businesses, own some assets or play it safe and buy low return bonds. In truth, there is much more to it.
How to solve this dilemma? Here are some steps to follow for beginner investors.
Find Your Purpose
No matter why you’re investing, there’s a suitable portfolio for you. It all depends on what you want to do with your profits. If you’re saving up for a long term goal, there are low yield bonds, which offer a low level of risk.
As mentioned earlier, most investors are risk averse. What about those who venture into the riskier investments though? First of all, you must understand that investment is not gambling, even with high risk assets.
It is true that higher risk provides higher return if the investment is successful. The investor must be paid a premium for the risk they take. Knowing the purpose behind your need for investment is the first key you require to opening your portfolio door.
Assess your Risk Tolerance
How much risk are you willing to take? Reverting back to the first key. With high risk and volatility, it is entirely possible to lose a chunk of money.
However, with a well diversified portfolio, that loss can be mitigated. Assessing your risk tolerance is an important step to figuring out where to allocate your resources. Do you go for the safe low yield municipal bonds and certificates of deposit?
Or do you risk high and allocate your resources in IPOs (initial public offerings) and high yield, long term bonds?
Study the Market
When it comes to designing an investment portfolio, you have countless options. Publicly traded companies are everywhere. Everyone is issuing stocks. What to buy, what to avoid? How volatile is the investment you’re considering? Is it in constant rise and decline?
Investors don’t just throw their money at flashy looking stocks or new “fad” bonds. They study the market. Companies are never stable, what goes up must come down. Study the performance of the company you are thinking about investing in, read past financial data.
Is the company heavily reliant on equity financing? Does it have too much debt? Are there any signs of collapse? Thoroughly check up on prospective investments before barging in. As stated before, investment is not gambling.
Have a Plan
What is your endgame? All investors have a plan; and it all goes back to the first key; Find your purpose. Your investment plan should be clear and precise. Do you use your profits to invest more?
Or do you save your winnings for a later time? Although your plan can change along the way, you must stick to your ultimate goal. Find your end game and plan accordingly how to get there.
Allocate your Resources
You found your purpose, assessed how much risk you’ll be willing to take, studied the market and came up with a brilliant plan. Now comes the fun part, allocate your resources.
Find how much disposable income you have set aside and make that money work for you. By now, if you followed the previous steps, you should know exactly where you want to put your money and what exactly you want to invest in.
Diversify your Investment Portfolio
Do not put all your eggs in one basket. Consider different asset types, buy stocks from different companies in different sectors, put some money in low risk assets or even think about buying stocks from foreign companies.
Diversification is vital; it helps mitigate any potential losses. If you lose money on one of your investments, you have others that will help ease the pain.
Look Out For New Investment Opportunities.
Investment portfolios are not something you set up and forget about. Be on constant lookout for new opportunities and attractive investments.
There are also some warning signs to indicate a crash or collapse of a stock, currency or company. Keep up to date with the latest business information and financial updates. It is never too late to enter the investment game.
Whether you need money a year or ten years from now, there is much more you can do with your money other than settling for the measly interest a regular bank savings account provides you.
Lucrative business opportunities are always around the corner. Invest right, play it smart and always do your research before jumping into any new investment opportunities.
As mentioned earlier, investment is not a gamble.
With the right information, meticulous research and smart resource allocation, you are very likely to come out on top. There is always a possibility of loss in the financial market. That’s why you should only use your disposable income for investment.
Risk is a factor that should always be considered when putting your money to work. You might have the stomach to take on a high risk/high reward investment but always consider the worst case scenario and do the best you can to hedge your losses.
The importance of diversification in any investment portfolio is unfathomable. Learn more along the way. A smart investor will learn from past losses and be on alert for new information and opportunities.
The use of a financial advisor at first is a smart idea. Not only will you learn the basics and pick up a lot of tips but a financial advisor is someone with years of experience who is unlikely to steer you wrong.
For those however who wish to venture into the financial market on their own, start slow, learn from mistakes, study the market and learn how to read a company’s financial sheets.
It might seem like a terrifying experience but, with the right tools, knowledge and proper funding, any average Joe can start right away on his very own portfolio and investment opportunities.