Tailoring a Portfolio

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This post and the next two are devoted to constructing an investment portfolio.  This first post takes up broad divisions – the mix of cash, stocks, and bonds — what professional investors refer to as asset allocation. The next post will focus on the portfolio’s bond assets and the third will discuss its stock assets.

Typically, a broker’s portfolio report begins with the overall amounts you have in cash, in stocks, and in bonds.  The report then gets into intricate detail, listing all the bonds, who issued each, the original “coupon” rate as a percent of the bond’s face amount, and its maturity date.  (See this earlier post for an explanation of these terms.) The broker’s report will probably also show how much you paid for each bond, its current value, and perhaps the interest payments you earned from it since the last report.  A comparable listing of the stocks in your portfolio will show the name of the issuing corporation, the number of shares you own, what you paid for them, their current value, and possibly dividend payments since the last report.

While these reports are useful to brokers, bankers, and accountants, portfolio managers look at holdings more broadly to consider how they can achieve two key objectives for you:

  1. Good diversification: An effort to avoid having too many eggs, meaning dollars, in one basket, that is too many of one security or type of security. If you could always pick the best, you would not need to diversify.  But perfect foresight is impossible, so spreading your wealth among different types of stocks and bonds will protect the portfolio from setbacks by ensuring that its different parts respond to events in different ways.  Such diversification of exposure allows your portfolio to secure the most gain with the least amount of risk.
  2. Serving the specific goals of the investor: Are your portfolio’s assets meant to provide retirement income?  To buy a vacation home? Or to pay for a newborn child’s college education? These and other long-term objectives will determine what sorts of stocks and bonds your portfolio should hold and how it should mix the types of securities to get the greatest prospective return for the least risk.

So think of the stocks and bonds in the portfolio not necessarily as individual holdings but rather as the best possible representatives of the sort of security that serves these basic aims.

There is no perfect mix.  Your right combination will depend heavily on your particular circumstances and preferences — what many in the investment business term your life-cycle/life-style situation.  Some people cope better than others with risk and occasional loses.  Those more suited to a riskier life style feel comfortable reaching for gains in a more volatile portfolio.  The mix you choose should also reflect where you are in your life cycle.  Young people investing for retirement, for example, will not need the money for years, so they can take more risk to earn greater returns than can older investors who are approaching the end of their working lives and have less opportunity to make up for an investment loss or time to wait for a market rebound after a setback.

Portfolios need to reflect such differences.  Young people, who will not need the money for years, particularly risk-takers, may want few or no bonds in their portfolios. They may want to concentrate on stocks, particularly smaller, less established stocks, because these, though more volatile than other investments, tend over time to gain more than bonds and more conservative stocks.  To be sure, stocks generally and particularly those of less established companies may suffer severe occasional reverses.  But as a group they eventually always come back.  An investor with a long time horizon can count on that recovery.  Someone older, with less opportunity to wait out a temporary setback, may want more bonds and stable, dividend-paying stocks. Retirees, who are already living off investment income, may also prefer bonds and dividend-paying stocks because they also tend to generate more immediate income than less established stocks.

There are many ways to combine stocks and bonds to meet portfolio goals. The aim is to learn their characteristics and create a good investment fit for your critical needs.  The next post will explain the role of bonds and the one following will do the same with stocks.