Investment Portfolio

What Is an Investment Portfolio?

An investment or financial portfolio is a basket of financial assets owned by a single investor. It includes many assets such as stocks, bonds, currencies, ETFs, cash, and other cash equivalents.

Although people perceive stocks, bonds, and cash as must-haves in a financial basket, it is not at all necessary to be the case every time. It can also include real estate, art, and other private financial instruments.

Building and managing a portfolio is a challenging job for beginners. However, it is your choice whether you want to do it at your discretion or want a money manager or any other expert in this field to manage your portfolio occasionally in exchange for a regular fee.

One of the main characteristics of forming a portfolio is considering diversification while choosing various components. Diversification is employed to reduce overall market risk by allocating appropriate amounts of funds to different assets or instruments and into different industries.

It aims at maximizing profits and minimizing risks to the maximum extent. However, there are a plethora of ways to diversify your portfolio. It should also reflect the risk tolerance of an investor.

We will talk more about diversification in the next section, briefly discussing the various components a basket of assets could contain.

As mentioned above, risk tolerance is a significant characteristic as it defines the limit to which an investor can accept potential losses to earn higher profits.

It also depends on your time before you reach your investment goal (if defined). For example, if you have invested in an instrument with an intent of long-term investment, you have more time to ride through the highs and lows of the market.

However, if it is for the short term, you will have to speculate accordingly to catch hold of the best available deal at the moment.

Let's move ahead and discuss more investment portfolios.

Components of a Portfolio

The financial assets that are included in a portfolio are called asset classes. The investor or the money manager must ensure the proper allocation of funds to these classes to maintain a balance by fulfilling diversification.

One can choose from the asset classes while building a basket of instruments:

1. Equity stocks

Stocks or company shares are the most common and easiest way of investing your money, making it one of the most common components of the portfolio. Buying a share essentially means that you are now a part owner in the company's stakeholding.

The size of your ownership depends on the number of shares you buy. Now how does this become a source of income for investors? Think about it. When you invest in a growing company, you're contributing towards its profit-earning goal.

Thus, the company owes you a part of its profits, although not necessarily. These returns are nothing but dividends.

Apart from this, the shares bought can be sold for a higher price depending on the company's performance in the stock market.

2. Bonds

Buying bonds means loaning money to an institution or an organization, also called the bond issuer. This issuer can be anyone from a company or an agency to the government of a country.

A bond is a debt instrument with a maturity date and a coupon rate or the rate of interest with which the issuer will return the principal amount.

Stocks are more volatile than bonds; hence bonds are considered a more stable investment opportunity. However, the risks and returns on bonds depend on the kind of bond issuer and must be scrutinized well before investing in them.

3. Mutual funds

A mutual fund is a pool of funds from many investors to purchase securities. It is managed by a professional fund-managing firm or entity registered with the government according to certain rules and regulations to be followed.

In other words, a trust pools money from a group of investors who share a common investment goal and have invested in the same financial instruments and other securities available in the financial market.

These are considered safer investments than dealing with individual shares of companies. For example, a pool of equity shares contains many shares of companies belonging to various industries.

Now, each industry works differently; thus, every factor or change in the morning economy or the markets will not have the same influence on all these industries. Thus diversification, in this way, helps minimize risks and shoot up the returns earned.

4. Exchange-traded funds (ETFs)

An ETF is a fund that consists of several similar stocks in a lot. That could mean stocks from a certain sector of the economy or stocks from even different countries.

These are also considered low-risk investments as they could be bought cheaply and hold a basket of different securities, thus increasing diversification. Moreover, it is professionally managed; thus, it does not require much time. 

5. Options

A derivative is a financial instrument that derives value from an underlying asset. Options are a type of derivative that allows investors to speculate on or hedge their funds against the volatility of an underlying asset or a stock.

There are two types of significant options. One is call options, and the other one is put options. Options are traded on an exchange platform.

6. Real estate

If looked into traditionally, real estate has been one of the safest long-term investments from the standpoint of growth.

One of the most important characteristics of investing in real estate is that while buying, the prospective owners can use leverage to buy the property by paying an upfront fee and then paying off the balance and the interest over time.

Investing in real estate has a high chance of success in terms of high returns, and a high-risk involvement should be balanced with a highly possible reward. 

Types of portfolios

There is no such concrete list of types of portfolios, as portfolios are built according to strategies adopted by an individual investor.

One can always maintain more than a single portfolio depending on the strategy that differs from the other portfolios and/or the investment scenario suitable for diverse needs. Below are some of the portfolios bifurcated based on the utility of one.

1. Income prospect

A portfolio that achieves a stable income is always risk-averse rather than scoring capital gains.

The investor would like to stay on the safe side and buy stocks solely based on the dividend perspective rather than a full-fledged due diligence of the company's growth potential.

2. Growth prospect 

Unlike a portfolio aimed at only being a source of regular income, a growth-oriented portfolio is more focused on the potential capital gains the investor expects.

This type of portfolio accounts for a greater risk as it mainly invests in growing and flourishing industries.

3. Value prospect 

This portfolio consists of securities based on the valuation done to evaluate whether they are undervalued or overvalued.

If the valuation turns out to be undervalued, the investor buys the security at a lower price and sells at a higher price when the stock reaches or surpasses its true value.

To sum up, this type of portfolio focuses on finding low-grade high-potential deals in the financial market and bagging the difference later.

Remember that these are just based on the main utility of the portfolios based on returns. Therefore, we can have a plethora of different portfolios based on unique requirements. 

Now that we have discussed portfolios in depth on a theoretical level let us look into how we can build a portfolio for ourselves! 

Steps in Building an Investment Portfolio

There is no list of universal codes to adhere to while building a portfolio. However, the ones listed below are the most basic guidelines to remember while creating one according to our investment needs.

a. The main objective

An investor or a financial manager must determine the direction of the portfolio that will drive the associated risks and returns.

b. Decide what kind of investor you are.

If you are an active investor, you will invest in stocks and/or securities that you think can grow in value over a short period.

Whereas, if you're a passive investor, you will likely buy long-term growth investments that will escalate in value over a long period.

c. Shortlisting the securities

Now that you know what kind of investor you are, you must choose different sets of components from those listed above and others.

One should consider diversifying the portfolio to balance the collective risks with the joint returns on all securities.

d. Determining maximum risk capacity

We need to know what capacity we hold to bear market risk. We can roughly calculate the same using the formula given below.

σ²_portfolio = w₁²σ₁² + w₂²σ₂² + 2w₁w₂ ρ₁,₂σ₁σ₂

Here,

• σ_²portfolio is the portfolio variance or the portfolio risk;
• w₁ is the portion of total funds invested in asset 1 of the portfolio;
• w₂ is the portion of total funds invested in asset 2 of the portfolio;
• ρ_1,2 is the coefficient correlation between the returns on asset 1 and asset 2;
• σ₁ is the standard deviation of returns from asset 1; and
• σ₂ is the standard deviation of returns from asset 2

Note that this formula can be extended to more than 2 securities.

e. Bifurcating funds proportionately

Now, allocating funds into different securities will be determined with a balanced proportion of risk and return associated with it. One should calculate and determine the risks and returns of individual securities and then allocate one's funds.

These are just the basic highlights of building a portfolio when new to financial markets. However, if you are a beginner, taking professional guidance is advisable to manage your funds more efficiently. 

Researched and authored by Anushka Raj Sonkar | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

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