How to start building a portfolio that’s right for you
As the big stock market indexes scale to new highs, seemingly daily, a growing number of novice investors are tempted to open online trading accounts and get into the game, for fear of missing out. Trouble is, this free-wheeling approach can lead to heavy-duty losses before you get too far out of the starting gate. Here are three key investment principles that novice investors often overlook when focusing on the thrill of the chase.
In investment terms, “risk” covers a lot of ground. Market risk is what most investors think of first. That’s essentially the risk associated with changing price levels for stocks. That change can be higher or lower and faster or slower, depending on the market cycle and the type of stock – otherwise known as “volatility.” Other risks include interest rate risk, sector risk, and home bias.
So how do you get a fix on your true tolerance for risk. If you swear up and down that you’re an ultra-conservative investor, and your portfolio is crammed with equity mutual funds, that’s hardly low-risk! It’s a fairly simple matter to fix with a questionnaire I use to draw up a realistic risk profile in my Integrated Wealth Management Service.
It’s not complicated. Ask yourself what level of loss you can stand in your portfolio over a given length of time. Are you okay with a drop of 10% over three months? Or a year? On a $50,000 portfolio, that’s $5,000. Remember, 10% is how much the stock market loses when it’s going through what’s called a “correction.” Be honest: Are you comfortable losing some or all of that $5,000 in a short time? Think of it this way: If you lose 10% on a $50,000 portfolio, you’ll have to make over 11% on your investments (now worth $45,000) to get back to breakeven. If that worries, you, maybe you’re not as risk-ready as you think.
Creating an honest risk profile will help you create a portfolio with just the right mix of safety, income, and growth assets that will truly meet your needs – and let you sleep nights. Which brings us to the next principle.
Asset allocation is the process of selecting asset classes to structure a portfolio that meets your performance objectives at your risk tolerance level. It’s important to allocate assets over a number of classes (including fixed-income, equity, and alternative investments) using a variety of strategies and assets, including stocks, bonds, preferred shares, mutual funds, and exchange-traded funds to ensure both tax-efficient growth and a level of capital preserveration to keep that income stream coming.
Are you currently diversifying your portfolio with enough non-correlated asset classes to your risk-tolerance level? Are you using hedging or income-generating strategies with options? These are not particularly easy questions for a do-it-yourself investor to answer. But if you’re having trouble sorting out how your various investment activities are affecting your overall returns, you might consider getting some help from an independent financial planner.
Novice investors typically tend to overlook one of the biggest factors in wealth creation: tax efficiency.
Research has shown that creating tax efficiency in your portfolio accounts on average for about 28% of overall long-term investment returns. Surprisingly, the factors with the next largest influence on your portfolio returns are the time you spend on management, which accounts for 26% of portfolio returns. Managing your emotions (all that fear and greed) adds up to about 20% ranking.
Getting the asset mix right accounts for about 17% of what goes into total returns. And security selection – something that investors spend the most time on – has only a 2% importance ranking in determining long-term portfolio outcomes.
This tells us that novice investors often get into by placing too much importance on the aspects of portfolio management that contribute the least to long-term portfolio growth.
It’s easy to get carried away with online trading in self-directed investment accounts, but you may be generating hefty (non-deductible) brokerage commissions and accumulating a sizable tax bill along the way. It all takes a big chunk out of your investment returns and puts it in someone else’s pocket.
Finally, remember that most of us tend to overestimate our capacity to deal with risk, investment volatility, and market losses, especially when we’re younger. Be realistic about your own tolerance for risk. Then allocate your assets accordingly with a growth tilt (more equity, less fixed-income) if you have higher risk tolerance, and vice-versa if you are a more conservative, income-seeking investor.