It’s never too early—or too late—to start investing. Whether you want to save for retirement, for a house, for college or some other future cost, creating a smart investment portfolio can help you get there faster. Here are some steps you should take in order to create a great portfolio.
Make Your Goals
First, sit down and determine your main financial goals. You may have longer-term goals or shorter-term goals that would benefit from different investment strategies, so knowing what your goals are and when to achieve them by is the first and most important step.
For example, if you’re saving for retirement, you should determine what age you’d like to retire, how many years you’ll be retired and an estimate of your cost of living during those years.
Next you need to determine how much time you have to invest and how much you can comfortably invest each year.
Determine Your Risk Tolerance
Once you have determined your goals, time-frame and annual investment, you can determine your risk tolerance and decide what kind of investment strategy you want to take.
All investments involve some risk, but some are riskier than others. When you take a greater risk, the rewards have the potential to be greater, but the losses can also be greater. With safer investments, you take a smaller risk, but you also receive a smaller reward or interest rate.
If you can afford to take greater risks, you might want to take an aggressive investment strategy. Equities, which depend on a company’s performance and, as a result, can be more volatile, are more risky than other types of investments. An example of an aggressive portfolio would be made up with about half of equity investments.
Unlike equities, fixed income securities offer returns in “fixed” payments, which could be monthly, yearly or semi-annually. For this reason, fixed income securities are a safer form of investment. A conservative investment strategy would include a majority of fixed income securities.
However, fixed income securities still come with risks. If you buy debt from a company, you run the risk that the company might not pay you back. To determine credit risk, credit ratings agencies, such as Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings, assign ratings to securities that helps determine their creditworthiness. Ratings range from AAA to C or D with AAA being the most creditworthy and C or D being the worst.
Securities that have been assigned high credit ratings are considered to be “investment grade.” Anything below BBB is considered to be high yield, which, as the name suggests, offers investors a high yield, but also has a higher risk of default.
Diversify Your Asset Allocation
You can break down fixed income securities, equities and non-cash equivalents into subclasses. It’s generally a good idea to have some mixture of the different asset types in your portfolio so you don’t depend on the performance of any one. Here are some examples of the common asset classes.
Fixed Income Securities
- Treasuries: The least risky form of fixed income securities are bonds issued by the United States government or treasury bonds. Since they are low-risk investments, treasuries also offer low interest rates compared with other bonds.
- Municipal bonds: These are another form of low-risk debt. These bonds are issued by states and local governments to finance public projects and to fund government operations. They are often secured by a government’s “general obligation” pledge, which means the government can use available resources, like tax revenues, to repay bond holders. Other municipal bonds may be secured by revenues, which could be toll revenues or utility revenues. Interest on municipal bonds is often higher than treasuries, but sometimes comparable, depending on the issuer and the maturity, or the date that the principal is repaid. Unlike other bonds, the interest earned from investing in municipal bonds is usually tax-free for the residents of the municipality in which the debt is issued.
- Corporate bonds: These are issued by corporations and are riskier than treasuries and municipal bonds. The risk depends on the particular company that is issuing the bonds as well as the market conditions. Since the risk is higher, it is compensated with higher interest rates than municipal bonds and treasuries. Adding corporate bonds, in particular high-yield corporate bonds, could increase returns in your portfolio, but it can also increase the risk.
- Asset-backed securities: An alternative to corporate bonds are asset-backed securities. These are backed by a loan, lease or other type of underlying asset. Examples include securities collateralized by home equity loans, student loans or auto loans.
(Also read: Basic Things To Know About Bonds.)
- Stocks: These are one of the more common options of equity. A stock of a company constitutes an equity or share in the company and are sold and traded among shareholders. Shareholders receive dividends, or payments made by a corporation, which comprise a portion of corporate profits.
Stocks usually take the form of either common stocks, which can be thought of the “ordinary” stocks of a company, or preferred stocks, which are higher-ranking stocks. This means that common stock holders do not get paid dividends until all preferred stockholders are paid in full.
- Mutual Funds: Instead of investing directly in a few stocks, you also have the option of investing in mutual funds, which include a basket of stocks. The biggest advantage of mutual funds is the diversification offered which can lower the risk. Additionally, investing in one mutual fund transfers the risk of buying and selling to a professional.
- Futures and options: These are possibly the riskiest form of equity. These allow you to bet on the future price of a stock. Since the risk is higher, the potential to earn higher returns is also higher.
Cash And Cash Equivalents
Though cash and cash equivalents offer little potential for gain, they are also virtually risk free. Many investors keep cash in their portfolios for the sake of safety.
Cash equivalents can include bank savings accounts, money market mutual funds, certificates of deposits or even treasury bills.
Cash and cash equivalents have the benefits of liquidity and are generally stable capital. They are good investments if you plan to use the money in less than five years or if it’s money for an emergency fund. These are less attractive options for medium-term or long-term investments because they are unlikely to keep up with inflation and taxes.
If you think you need professional help in creating a portfolio, an investment counselor or stockbroker may be able to offer good advice. Be sure to tell them your goals, timeline, investment strategy and risk appetite.