Building an investment portfolio
Investing plays an important role in financial planning as it may help you to keep pace or even cope with inflation to achieve your financial goals. You can allocate the remaining amount for investing after you deduct necessary spending and savings from your income. A well-planned portfolio can help you ride out stock market ups and downs and adjust your risk exposure.
Investing is a process to hold a portfolio that suits your risk appetite with a mix of investment products to keep your portfolio afloat in any economic climate.
To build your investment portfolio, consider the following key steps:
1. Know yourself
The first step in portfolio planning is to ask yourself: ‘Why am I investing?’ Your investment objectives determine the types of investment you make and the level of risk you take. If you don't identify your priorities clearly, you could end up with an investment product or portfolio that doesn't meet your needs.
Every investor wants to make a profit. But it’s essential to distinguish between investing for long-term gain such as saving for retirement and trying to preserve capital to make short-term purchases. If a long-term gain is your goal, you should keep an investment even if there are short-term market fluctuations. If you need the money short-term, choose more conservative investments. If you are young and aim at building your retirement savings in the next 30 years or so, your investment objective may be capital growth. Alternatively if are older, capital protection might then be a priority for you.
You should also consider both risks and returns. As a general rule, the higher the return sought, the higher the risk. "Maximising returns by minimising risk" is an unrealistic objective. And "get-rich-quick" targets can expose you to inappropriate risk.
Your risk tolerance is your ability and willingness to tolerate a decline in your investment values. Young people can usually afford to take higher risks, while older people tend to be more conservative.
Remember, age is not the only factor affecting risk tolerance. Other factors include:
- Investment time horizon: The longer you can weather market volatility, the higher your risk tolerance.
- Liquidity needs: The higher your needs for ready cash, the more you should keep as liquid assets. You should also think about setting aside cash of at least three to six months of your regular expenses to meet any contingencies.
- Financial resources: If you only have tiny resources, then you might not be able to take too much risk.
2. Know your investments
When it comes to making financial decisions, it is important for you to adopt and apply responsible attitudes towards investing and money management. Each type of investment has its own features and downside risks. You should understand the nature and risk of any investment offered to you and remember to read the offering documents for details related to the investment products eg stocks, bond and funds.
Find out whether the fees and charges are payable by you directly, or are set against the investments. Costs are important because they lower your returns. Get the facts before you invest. Also, remember that past performance provides no guarantee of future price.
Check whether an investment vehicle is traded on an exchange or in the over-the-counter market. Liquidity varies between these markets, and this determines how easily you can sell your investment.
Always remember the golden rule: If an investment looks too good to be true, then it probably is!
3. Diversify portfolio risk
When investing, you cannot totally avoid risks. The easiest way for you to manage risk is to diversify. All markets may not move in tandem, and at times one type of financial asset will perform better than another.
Diversification means owning different types of investments, different issues of the same type, different currencies, and may be even spreading your investments across several countries. Risk levels can even vary within a single type of investment product - for example, a single country equity fund will generally be riskier than a globally diversified equity fund.
A balanced portfolio, investing in a variety of asset types, tends to be less volatile than one investing in a single type. Allocating your assets means determining an appropriate asset mix so that the proportion of money invested in each asset class ties in with your risk tolerance.
You need to first set the weight of each asset class in your portfolio, then, decide what to invest within each asset class. Stock selection is all-important when you buy shares - individual companies must be carefully analysed. Some investors favour ‘fundamental analysis’ by looking at corporate governance and management quality, future prospects (whether a company engages in an emerging or a sunset industry), as well as the financial health. Others may prefer ‘technical analysis’, using charts to spot the appropriate timing to buy or sell their stakes against historical stock price trends.
Another way to lower your portfolio risk is to ‘hedge’ using derivatives such as futures and options. By hedging, you may be able to offset any expected fall in the value of your stock portfolio with an anticipated gain in your derivative investments. However, investments in derivatives are complex and have their own unique risk features. Make sure you fully understand their characteristics and risks before trading in them.
When investing, you have to limit your risks to a level acceptable to you. There is no such thing as a risk-free investment. So, before committing to any investment, you should make sure you understand the possible downside. Learn more about investment risks.
4. Conduct regular review
Investing is an on-going responsibility. Regardless of whether you are entrusting your money with professional fund managers, eg investing in funds under your MPF scheme/ retail funds in your portfolio, or you make direct investment in different assets, you should regularly review the performance of your portfolio, particularly when there is a change to your life stage, and take action to adjust if it can no longer suit your investment objectives.
5. Rebalancing your portfolio
Things change over time. You need to review your investment plan regularly, and certainly when there are significant changes in your own circumstances or in market conditions. If your portfolio has deviated from your objectives, you may need to re-balance it. Remember, portfolio planning is a dynamic and continuous process.
In meeting your financial goals, it’s considered best practice to review your portfolio on a regular basis and rebalance your investments when necessary. Rebalancing protects you from having a portfolio that overemphasises one or more asset classes.
How to diversify your assets
Stephen holds 80% of his assets in stocks, and 20% in cash. As he works in technology and follows the industry, his portfolio consists entirely of technology stocks. Is Stephen’s portfolio diversified enough?
Not really! Although Stephen has diversified into two asset classes, cash and stocks, he has allocated a large amount (80%) of his assets to technology stocks. Concentrating investment in a single asset class (stocks) of a single industry (technology) exposes Stephen to risks if the technology sector performs poorly.
Individual investments in the same asset class tend to move in similar directions. Incorporating more asset classes (such as property, bonds and commodities including precious metals), Stephen’s portfolio is more diversified. Through diversification, Stephen will be able to manage the risks in his portfolio so that a more positive performance of some investments will counter the negative performance of others.