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Building an investment portfolio: How to allocate assets for optimal results

At a glance:

  • Allocating assets for short, intermediate, and long-term goals

  • Allocating resources for investment

  • Asset allocation based on your risk tolerance

  • Asset allocation and investment risk

  • Allocating assets for efficiency

  • How to diversify through mutual funds

  • Summary of creating a portfolio

  • Practical ideas you can start with today

Building a portfolio entails combining different investments to work toward your financial goals. You certainly want to get the highest return, but how much risk are you willing to take, and how much risk can you take to achieve those goals?

Asset allocation does not assure a profit or protect against a loss. Therefore, you should consider factors such as your risk tolerance, risk aversion, and available and future resources, as well as inflation and taxes to create just the right mix of investments. You also need to know what types of investments meet your needs.

Allocating assets for short, intermediate, and long-term goals

Since the odds are against your getting rich quickly or inheriting a million dollars, you will need to assess your financial situation carefully and then construct a portfolio so that you can work toward building wealth over time. To do this, you first need to look at your time horizon.

Some general rules

For the short term, fixed-income investments and cash investments may have the highest potential returns. Cash, certificates of deposit, and certain bonds are typically recommended for short-term investing. For the long term, equities (stocks) have been shown to have higher historic returns than other investments. (Past performance is no guarantee of future results.)

Therefore, if your time horizon spans decades, you may want to have a large percentage of stocks in your portfolio to potentially maximize your return. Conversely, if you are investing for a time horizon of only a few months or a few years, it may be better to stash your cash in more conservative (and less volatile) investments.

What to keep in mind for your time horizon

When building an investment portfolio, a good tool is to keep the following considerations in mind: your current age, your immediate need for the money you are saving, and your assumed life expectancy. If you are 25 and do not need to use the money you are planning to invest in the near future, you may want to consider allocating a large portion of your investment dollars to more volatile investments such as stocks.

This volatility is sometimes rapid and unpredictable. Market risk may affect a single issuer, sector of the economy, industry or the market as a whole. If you are a 70-year-old retiree and need income for the present, more secure investments such as bonds and other fixed-income securities may be more appropriate for you.

Learn more about the risks of fixed-income investments. There are risks associated with fixed-income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities.

In general, the younger you are, the more risk you can afford. As you get older, you may want to increase the percentage of fixed-income securities in your portfolio. If your investments in stocks decline during a market downturn, your life expectancy could prevent you from regaining what you have lost.

Allocating resources for investment

How much money you have (or want) to invest plays a big part in what your portfolio will look like. If you do not have much, you may at first be limited to only a few investment choices. Conversely, if you have plenty of discretionary cash, you are open to a much wider choice of investments.

Learn your net worth

Your entire net worth is invested in one way or another. An important step for all investors is to determine their net worth. Take inventory of all the valuable things you own. Subtract your debts. What's left is your net worth. You can use your net worth to gauge your risk tolerance for additional investments. You may also be surprised to learn how you have your assets allocated.

You can use this information to determine how much capital to invest and how to allocate it.

Asset allocation based on your risk tolerance

Don't confuse risk tolerance with risk aversion. No sane person wants to take risk for the sake of taking risk. Sane people are risk averse. Some are more averse than others. Risk tolerance is quite something else—although there might be a connection.

The role of risk tolerance

Risk tolerance is the amount of risk you can afford to take when selecting your investment options. The more risk you can afford to take, the less averse you feel about risk. It is a key factor in building the investment portfolio that is right for you. Acting outside of your risk tolerance level could result in sleepless nights worrying about a rash decision you made.

The role of high net worth

Often, an investor's ability to meet current financial responsibilities regardless of the results of his or her investment will influence his or her aversion to risk. If you have a high net worth and can afford to lose some of your invested money, you may feel comfortable speculating in potentially volatile investments. Conversely, if you have a low tolerance for risk (or few dollars to spare), it may be wise to stick to conservative investments.

When making asset allocation decisions, consider your risk tolerance as well as your risk aversion. It will help you make wiser investment decisions.

Asset allocation and investment risk

Asset allocation is a technique used to balance the risk of a portfolio in such a way as to avoid taking too much risk for a given level of expected return. Investment risk is usually measured by how much the investment price varies. The risk is also compared to the variance of all similar investments.

Investment risk

We tend to think of investment risk as the chance of loss due to the uncertainty of future events. Many factors (or risks) can affect the values of your investments. For example, there are risks in political systems that can reduce the value of an investment. A company you invest in may undergo unforeseen changes in management. Investor emotions may be unpredictable. Uncertainties in exchanges, rates of currencies, and in interest rates also affect investments.

Calculated risk

Usually an investor can deal with risk in two possible ways: one is to simply gamble with it, and the other is to study as many factors as possible and choose the most promising course of action. This latter option is called calculated risk.

Beta

Investment risk can also be measured by the volatility of an investment. The volatility is the amount that the price fluctuates above and below the previous price. Economists have developed a mathematical tool to "measure" this fluctuation. The Greek letter beta (β) represents this measurement.

A beta of one means that an investment is as volatile as the rest of the market. The higher the beta, the higher the risk; the lower the beta, the lower the risk. Beta is a useful tool in selecting investments for your portfolio and to measure the risk in your portfolio.

Allocating assets for efficiency

Unless you are a financial thrill-seeker or you have a deadly fear of losing it all, you may want to diversify your investments. While diversification does not assure a profit or protect against loss, it is an effective way to help avoid losing money on a single bad investment.

What history says about returns

Historical analysis of those portfolios having different proportions of cash, bonds, stocks, and other assets reveals that, for a given return, there are optimal mixes of assets that produce different returns with minimal risk. These portfolios are considered to be "efficient" because they take the least amount of risk for a given return.

Once you understand the personal factors that are important to building your investment portfolio, you can begin to choose from the investment choices that best fit your personal criteria. To select investments wisely, you should study how they work, how they interact with other investments, and how to use them to help achieve your goals.

How to diversify through mutual funds

Many investors use mutual funds to diversify their investments and to allocate assets across a broad range of investments.

How mutual funds diversify

Mutual funds are ready-made portfolios of investments. Mutual fund portfolio managers allocate the funds' dollars in different ways to achieve different investment goals; for example, to meet the goal of growth, a manager may concentrate on growth stocks and allocate lesser amounts of the fund to bonds and cash. Since mutual funds are already set up with certain percentages of stocks, bonds, and cash, you may be able to find funds that meet your personal criteria for diversification. If you do, you will save yourself the time and arithmetic of building your own portfolio.

Each mutual fund has its own investment objectives. If you are seeking growth, there are growth funds; if income, use income funds. If you are looking for a simple way to take advantage of asset allocation, asset allocation mutual funds use allocation formulas to manage the percentages of each type of security held as the market changes, that seek to achieve the fund's allocation objective.

The advantage of mutual funds

Using mutual funds for diversification and allocation is a simple way to work toward building a portfolio that does not require a lot of capital and trading. But you still need to know what you're doing. In addition to diversification, mutual funds offer other advantages that are worth considering, such as economies of scale and liquidity.

In addition to the advantages of mutual funds, make sure to consider the risks of mutual funds. Mutual funds have fees and expenses, and investing in them also involves risks including but not limited to the possible loss of principal, all of which are all outlined in the prospectus.

Summary of creating a portfolio

Common sense tells us that investing all your capital into one investment is like "putting all your eggs into one basket." This could be very dangerous. Knowledgeable investors build their portfolios by combining different investments to work toward achieving their investment goals and reduce their investment risk.

The amount of capital that one allocates to an investment within a portfolio is determined by the risk and reward characteristics of that investment. Combining investments with different risk-reward characteristics tends to balance the overall risk of the portfolio. This process is called asset allocation.

Practical ideas you can start with today

Determine the investment time horizon for each of your major life goals.

Determine your risk tolerance.

This content was created in partnership with the Financial Fitness Group, a FINRA-backed e-learning platform focused on improving personal financial literacy in the U.S.

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