Portfolio Design: An Introduction

I was recently speaking to someone at a dinner who wanted to get started with investing but wasn’t sure where to start with their portfolio design. They’d found a broker online and created an account, but didn’t feel confident enough to start acquiring assets. I spent the evening talking to them about my own investment principles and they then started asking me questions about what I thought they should do next. Below is a brief overview of some of the things we spoke about;

Setting your goals
Before diving into the world of investing, the first thing to do is know what you’re trying to achieve. You can define this in a number of ways, for example;

  1. Are you trying to grow your wealth or produce an income?
  2. What are you trying to fund?
  3. How much wealth/income do you think you need to do this?
  4. How comfortable are you with volatility in your investments?

Essentially, you need to know how you will measure progress – what will a ‘good’ year look like for you and what will a ‘bad’ one look like. It helps to give you something to work towards and stops you from accumulating a ‘random assortment’ of investments.

Build a Strategy
I’ve written a number of articles about my own investing strategy. Your strategy will help you decide how to act when different things happen and also plays a key role in helping you to identify suitable investments. Your strategy helps you to work towards your goal. For example, if you wanted your investment to pay an income of $50,000, investing in a company that pays no dividend might not be the best option.

My own strategy covers issues such as portfolio costs, preferred investment timeframes, and my investing ‘style’ but isn’t a particularly complex document. In fact, it’s important that it’s something personal to you, that you can understand and remember, as you’re going to be implementing it every day when you invest.

Portfolio Design
Once you’ve picked your goals and strategy for achieving them, you can start selecting investments that will help you to achieve them. Traditional financial advisors usually spread investments across a dichotomy of ‘high risk vs. low risk’ or ‘aggressive vs conservative’. Generally speaking, the more ‘risky’ or ‘aggressive’ your portfolio, the more equities you will hold, and vice versa for those investors who are older, more cautious or less able to suffer drawdowns in capital.

The main goal of a conservative investment design is to protect capital by investing in assets that are traditionally seen as ‘safe’. Bonds typically fall into this category, as they are fixed-term loans to a company or public body, usually secured against assets or the inherent ‘creditworthiness’ of the institution.

By contrast, an ‘aggressive’ portfolio design will seek maximum capital growth by investing in companies with high growth potential, sometimes operating in emerging markets and which have limited track record. An example might have been Google or Amazon around 20 years ago – limited track record, an unproven business model, but potentially incredible returns.

Personally, I’m not a big fan of these ‘X vs Y’ type portfolio designs, as I feel they fundamentally misunderstand the nature of investing. In my opinion, they seek to determine the appropriateness of an investment based on an investors risk profile but most people are terrible risk analysts and even worse at understanding their own risk tolerances.

For example, whenever I speak to most ‘rookie’ investors, they tell me one of two things. Either they’re ‘not bothered’ about investments losing value because ‘markets always go up over time’ or they’re ‘afraid of losing money’. Neither description is really an accurate representation of the way markets work.

The FTSE100 index, biggest 100 companies in the UK hit 6000 in 1999. In 2020, it’s gone precisely nowhere, still being valued at 6000. Some of the companies from the original 100 are no longer in existence, some are far more valuable. Depending on the companies you picked for your portfolio, you could be very wealthy, or not.

Likewise, after a few questions with investor number 2, it usually becomes obvious that they feel highly uncomfortable with volatility. The idea that one day they might open their brokerage account and see their investment valued at 50% of what they paid for it fills them with dread…even if that same investment were to quadruple in value over the next two years.

Choosing your Investments
I tend to design my portfolio in a slightly different manner. Yes, risk is important to measure, monitor and mitigate, but it shouldn’t be the only consideration when building your portfolio.

  1. Choose stocks that have good future prospects, are diversified by size, geographic location and type of business. Compare different stocks to select those with the best qualities and then research a short-list to determine the opportunities and risks specific to that company.
  2. Consider adding bonds/debt instruments to your portfolio which have a spread of coupon, maturity, bond type and credit rating. In 2020, many bonds are, in my opinion, fairly worthless investments due to their extremely poor yields.
  3. Examine investment trusts and collective investments in specialist areas. For example, I hold a number of infrastructure investments and renewable energy funds which are professionally managed by experts in those fields. Be wary of high fees in these investments; they’re not always worth the cost!

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