Among the questions investors ask me most often, those having to do with the mechanics of building a portfolio are at the top of the list. Constructing a portfolio is a bit like a fingerprint: Everybody’s situation is unique.
For that reason, I can’t recommend a specific one-size-fits-all solution—but I can offer some ideas and practices to get you started and help you along the way.
Most money management firms distinguish between three broad types of investors:
Conservative investors rely on their portfolio for current income and so need to maintain cash flow across a rolling two-year window, which is generally as long as it takes even in an extended downturn to play out.
Moderate investors have outside income sources and a little more time for the market to recover from a bad year, so they can afford to take on more risk and aim for more reward.
And everyone else is generally considered Aggressive.
The main focus is the time you have before you’ll need to draw down the assets in order to pay the bills, but you should also consider how you tolerate risk and potential volatility. If you’re going to lose sleep over more aggressive investments, dial the risk down a bit by focusing on more moderate and conservative strategies.
If you’re already living off your investment portfolio or plan to start spending it down in the next year or so, I highly recommend a more conservative approach. You may want to allocate at least enough funds to pay a year of expenses into relatively stable assets that are unlikely to decline in value much or at all, such as cash, bonds, CD, money market accounts, and so forth.
At that point, you could consider riskier assets like stocks that might decline substantially in a given year but have always bounced back strong in the past. And if you need income, dividend-paying stocks can help generate it throughout most of the cycle.
One rule of thumb some investors like is to subtract your age from 110, with the resulting number being the percentage you allocate to stocks. For example, if you are 60 years old, you could have 50% of your portfolio in stocks. The old formula was to subtract your age from 100, but with people living longer, many think 110 (or some even say 120) is better to make sure you get enough exposure to growth to increase the odds that your money will last as long as you need it to.
Once you decide how much you want to invest in stocks, it’s time to start thinking about which stocks you want to buy. Diversification is one of the first principles most investors learn, usually in the form of the proverbial “eggs” of capital spread across multiple market baskets to reduce the odds of catastrophic risk wiping out all the assets at once.
In my 30 years on Wall Street, I’ve found that spreading your bets is more than just a good defensive strategy. Allocate your assets correctly, and you can actually generate higher overall returns as well as reduce your net risk.
If your cash is limited, you may only be able to buy a few names. You won’t be as diversified right off the bat, but you can work toward that. And that’s just fine, because one of Wall Street’s guilty secrets is that you don’t actually need hundreds of separate positions in order to have a well-diversified portfolio.
Many traders do quite well with a more concentrated portfolio, especially for relatively short periods of time.
I hope that gives you some guidance on where to get started with your portfolio allocation. Remember, your first step should be determining your personal risk tolerance and time horizon. Once you know those two factors, you’ll have a much easier time determining the right investments for your money.
