Last updated on August 21st, 2024 at 11:16 am
A well-made portfolio could be the key to your long-term plans. If you are a beginner, just know this: Portfolio construction is the foundation of smart investing. In this post, we are here to guide you through the process of portfolio construction in easy-to-understand words.
Before we proceed to the main process, let’s clarify the basics. We will start with the key question, “What is a Portfolio?”
What is a Portfolio?
A portfolio is a pool of investments that consists of various types of assets that an investor owns. It entails all types of assets, not just stocks, bonds, and derivatives; it also refers to real estate investments, commodities, and other cash equivalents.
Have you ever tried out apps like Groww or other Angel ones? These apps summarise all your invested stocks, mutual funds, and derivatives in one place on your home page or your profile to show your total invested amount and profit for an overview—that’s your portfolio.
Now that you understand what a portfolio is, I’m sure you will easily understand the next part.
What is Portfolio Construction?
Portfolio construction is the process of investing in different types of assets that match your (Investor’s) investment goals, risk tolerance, and time horizon. The primary aim of constructing a portfolio is to create a well-balanced and manageable pool of investments that will help you reach your investment goals.
Why is Portfolio Construction Important?
A portfolio lets the investors have an overview of all investments in one place, so you don’t have to check on every asset individually. It also shows how much of a total profit or loss all your investments made altogether. This helps you understand whether your assets are performing as expected.
A well-constructed portfolio can protect you from major losses caused by sudden market downturns. The performance of all your assets is in one place, so you can rebalance according to your investment needs and reduce the chances of any one investment dragging down your overall performance.
It ensures that your investments are not too risky or lack enough growth potential to reach your ultimate investment goal. The process of portfolio construction allows you to make intentional, informed decisions about where and how to invest your money.
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Steps In Portfolio Construction
1. Determine Your Investment Goal
Your investment goal is the first and most important thing, your ultimate goal. When you decide to invest, you must have had some idea about why you are investing. Maybe it’s for saving for the future, planning for retirement, buying a car, or just earning crazy money! Whatever it is, it will be the shaping point for your portfolio.
Your Investment goal will decide what strategies you will use to construct the perfect portfolio and help you reach it.
2. Understand Your Risk Capacity
Your risk capacity or tolerance indicates how much money you can risk. The financial market is risky, and even with the safest investments, things can sometimes go wrong. So, before you set out on your investment journey, make sure you have everything cleared.
Your risk tolerance is a key factor in determining what type of portfolio you should build. If you have a higher risk capacity, i.e., you can risk huge amounts of capital, you can aim for higher-earning potential investments like stocks, which can double or bring your investment down.
In the same way, if your risk capacity is low, i.e., you cannot risk too much capital, you could opt for low-risk investments like mutual funds, bonds, etc. These investments are not as explosive as high-risk options, but they ensure that you don’t risk your principal amount.
Once you have decided how much you can risk, you will have a clear idea about what types of assets you should invest to keep your portfolio balanced. Understanding your risk tolerance is key to portfolio construction because it helps you decide the right balance between risky assets (like stocks) and safer ones (like bonds).
Now that you have a clear idea of your investment goal and how much you can risk, we can move on to the core part: selecting the right assets.
3. Asset Selection
While selecting your investment options, keep three things in mind: your goal, risk capacity, and time horizon (how much time you have to stay invested). These three key points will help you select the perfect set of assets to build a balanced portfolio.
If you have a higher risk capacity, you should invest in more high-earning options like stocks. You can select a higher number of stocks for your portfolio and fewer safer options to manage the risk. This portfolio will be risky but also offer a huge return potential.
If you have a lower risk tolerance, make a portfolio that balances risky and safe investments. If you invest in risky options like stocks, try to balance your portfolio by selecting a safe option like a mutual fund or bond so you don’t risk too much.
If you don’t want to risk anything, opt for safe options like FDs, mutual funds, bonds, etc. They will offer slow growth but no risk.
So, if you are a student with moderate risk capacity, build a balanced portfolio. If you are a young professional with a higher risk capacity and a hungry appetite for earning or investing for retirement, opt for a risky portfolio. Or, if you want a safe option, invest more in bonds and mutual funds.
4. Diversification
As an investor, you should always know this: Diversification is the core of portfolio construction. What is diversification? It is the process of investing in different types of assets with different classes and features to reduce risk.
The general idea here is that with diversification, you will always have other assets to rely on. Suppose one of your investments suddenly started performing poorly. If you have diversified and invested in assets from a different industry that is currently performing well, it will help to balance your currently poor-performing investments. A well-constructed portfolio will always withstand market downturns.
5. Rebalance Regularly
The financial market has only one certainty: It is always uncertain. An asset that you thought would reach soaring heights can drop within a week. So, it is important that you check your portfolio regularly and keep it updated according to the current market. Always remember your investment goals and risk tolerance; it will help you keep your portfolio aligned with them.
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Final Statement
Portfolio construction may look complicated, but it doesn’t have to be. If you follow a systematic approach, you can build an investment portfolio that will help you achieve your financial goals, stay per your risk capacity, and reach the goal in time.
Remember, successful investing is less about picking the “right” stocks and more about constructing a well-balanced and diversified portfolio that can withstand market fluctuations.
To summarize, portfolio construction involves setting clear goals, assessing risk tolerance, deciding on an asset allocation, diversifying your investments, and regularly rebalancing your portfolio. By following these steps, you’ll be well on your way to achieving your financial goals through thoughtful and strategic investing.
Strong portfolio construction is the foundation for success, whether you’re saving for retirement, a home, or any other financial goal.
FAQs
What are the techniques of portfolio construction?
Portfolio construction techniques include asset allocation, diversification, and rebalancing, which help spread investments across different assets, manage risk, and ensure the portfolio stays aligned with your goals.
What are the benefits of portfolio construction?
Portfolio construction helps manage risk, improves the chance of steady growth, and ensures your investments align with your financial goals by balancing different types of assets.
How to construct a portfolio?
To construct a portfolio, choose a mix of different investments based on your financial goals, risk tolerance, and time frame. Then, diversify your assets to reduce risk and regularly adjust to maintain balance.