26 Feb Ten tips for building an investment portfolio that works
Warren Buffett once said “Investing is simple, but not easy”. It’s certainly easy to overcomplicate things, allow your emotions to drive your investment decisions and to follow the herd.
In investing there are no absolute right or wrong answers, only better or worse solutions. Better solutions are founded in a process that encompasses insight into the problem (‘How should I invest?’), are focused on reducing uncertainty (with as little risk as possible) and a robust and consistent decision-making process (‘Should I go right or left at this decision point?’). As Albert Einstein stated, “Make it as simple as possible but no simpler”.
If you can bear the following guidelines in mind, you give yourself a far greater chance of constructing a portfolio that works whatever is going on in the markets.
- Start with the end in mind
What is it that you want to achieve from your portfolio? Remember, a portfolio is not a plan. Start with the goals you want to achieve in your life – determine the ‘what’ (for example, ‘To reach financial independence at age 60, when paid work becomes optional’), the ‘how much’ (such as ‘supporting a lifestyle costing £50,000 per annum’) and the ‘why’ (such as ‘in order that I can pursue my passion to travel the world’). To help you get started on this you can access our financial planning tool free of charge here.
- The key to success is striking the right balance
Capitalism works and you should use it to do the heavy lifting as you try to generate returns from your portfolio as either owner (equities) or lender (bonds). Finding the right balance between the two is key because, of all the influencing factors, it has the greatest impact on both risk and return.
- Understand your risk profile
Understanding your risk profile will help you to achieve the right balance of assets within your portfolio. There are three components that define how much investment risk you need to take: the first component is how much risk you can tolerate, which is a psychological trait; the second is defining your financial capacity for losses, which is a function of your wealth and future lifestyle needs and the third is the financial risk that you need to take (which is driven by the investment return that you require) to achieve your goals. Aligning these three components is one of the most important processes you will go through if you are to have a successful investment experience. Only once you understand this can a sensible and suitable investment portfolio be structured.
- Don’t put all of your investment eggs in one basket
Diversification really is the only free lunch in investing.
- Investing is a ‘get rich slow’ process
Any ‘investment opportunity’ which appears to promise stellar returns should be treated with extreme caution. And then rejected.
- Risk and reward are related – there are no low risk, high return investments
See 5 above.
- Price volatility is not the same as risk
Liquid investments fluctuate in value based on supply and demand. In general terms stockmarkets are falling one third of the time, recovering one third of the time and breaking new heights for the remainder. Don’t turn a temporary fall in value into a permanent loss of capital by baling out when things look bad.
- Capturing the market return is a valid objective
The evidence tells us that stockmarkets work pretty well – they are a ‘zero-sum game’ before costs (i.e. if there are only two investors in a hypothetical market and the first owns all the stocks that beat the market, then, by definition the other investor must own all the ones which underperform it. The aggregate of their two portfolios is the market return, before costs).
The evidence (of many rigorous academic studies over many decades) tells us that few professionals ‘win’ over the sorts of time frames in which most investors are interested and that they are virtually impossible to identify in advance. Using ‘passive’ funds that seek to deliver the return of the markets, rather than to beat them, make sense.
- Investment costs truly matter
In investing, you get what you don’t pay for, as John Bogle, founder of Vanguard, wisely said. Do your homework and make sure you know the TOTAL COST of anything in which you are planning to invest.
- Manage yourself as tightly as your investments
Making hasty, emotion-driven, investment decisions is proven to destroy wealth unnecessarily.