You've identified your goals and done some basic research. You understand the difference between a stock and a bond. But how do you actually go about creating an investment portfolio? What specific investments are right for you? What resources are out there to help you with investment decisions? Do you need a financial planner to help you get started?
It is an almost universally accepted concept that any portfolio should include a mix of investments. These investments could include a mix of stocks, bonds, mutual funds, and other investment vehicles. A portfolio should also be balanced. That is, the portfolio should contain investments with varying levels of risk to help minimize exposure, should one of the portfolio holdings decline significantly.
Many investors make the mistake of putting all their eggs in one basket. For example, if you invest in one stock, and that stock goes through the roof, a fortune can be made. On the other hand, that stock can lose all its value, resulting in a total loss of your investment. Spreading your investment over several asset classes should help reduce your risk of losing your entire investment.
Asset allocation is one of the first steps in creating a diversified investment portfolio. Asset allocation is the concept of deciding how your investment dollars should be allocated among broad investment classes, such as stocks, bonds, and cash equivalents. That is, rather than focusing on individual investments (such as which company's stock to buy), asset allocation approaches diversification from a more general viewpoint. For example, what percent of your portfolio should be in stocks? The underlying principle is that different classes of investments have shown different rates of return and levels of price volatility over time. Also, since different asset classes respond differently to the same news, your stocks may go down while your bonds go up, or vice versa. Diversifying your investments over different asset classes will help you minimize volatility while maximizing potential return.
So, how do you choose the mix that's right for you? Countless resources are available to assist you, including interactive tools and sample allocation models. Most of these take a number of variables--some objective (e.g., your age, the financial resources available to you, your time frames), some subjective (e.g., your tolerance for risk, your outlook on the economy)--and suggest a possible allocation mix. Tailoring this suggested allocation mix to your needs is up to you. Rather than do it yourself, you can work with a financial advisor.
Diversification isn't limited to asset allocation, either. It is also important to own different investments with different levels of volatility, even within an investment class. For example, if you want to invest a large percentage of your investment dollars in stocks, that may be all right--stocks may be inherently more volatile than bonds or money markets, but you may have the ability to balance a stock portfolio with both higher-volatility and lower-volatility stocks and to reduce exposure that way.
Diversification also naturally results from investing in mutual funds instead of in individual securities. Most mutual funds invest in dozens to hundreds of securities, including stocks, bonds, or other investment vehicles. Purchasing shares in a mutual fund reduces your exposure to any one security. In addition to instant diversification, you get the benefit of a professional money manager making investment decisions on your behalf.
Your goal is to get the highest return on your investment that you can, within your comfort level. Your tolerance for risk likely depends on several factors, including your objectives and goals, timelines for using this money, life stage, personality, knowledge, and investment experience. You'll want to choose a mix of investments that has the potential to provide the return you want at the level of risk you feel comfortable with.
For that reason, an investment professional will normally ask you questions so that he or she can gauge your risk tolerance, then tailor a portfolio to your risk profile.
A wealth of investment information is available if you want to do your own research before making investment decisions. Many brokerage houses make their research available for free to customers through the Internet, for example.
However, many people aren't comfortable sifting through balance sheets, profit-and-loss statements, and performance reports. Or, they just don't know enough to make use of the information available to them. Others just don't have the time or energy.
For these people, an investment advisor or professional can be invaluable. There are three general groups that investment advisors and professionals fall into: stockbrokers, professional money managers, and financial planners.
Stockbrokers work for brokerage houses. Their level of knowledge and skill is highly variable, and they generally work on commission. If you're working with a stockbroker, consider to the extent possible whether the broker seems to have your best interests at heart and listens well to your goals and objectives. Also, verify that the broker has the requisite skill and knowledge to assist you in your investment decisions. Ask for references, and check with the Securities and Exchange Commission for any customer complaints or disciplinary actions that may have been brought against the broker. Ask friends, family, and coworkers if they can recommend brokers whom they have used and worked well with.
Professional money managers were once available only for extremely high net-worth individuals. But that has changed a bit now that competition for investment dollars has grown so much, due in part to the proliferation of discount brokers on the Internet. Now, many professional money managers have considerably lowered their initial investment requirements in an effort to attract more clients.
A professional money manager designs an investment portfolio tailored to the client's investment objectives. Fees are usually based on a sliding scale as a percent of assets under management--the more in the account, the less of a percentage you are charged. Management fees and expenses can vary widely among managers, and all fees and charges should be fully disclosed.
As with any professional, it is advisable to do some investigative work before deciding which manager will best suit your needs.
A financial planner is a professional advisor who can help you set financial goals and who can develop and help implement an appropriate financial plan that manages all aspects of your financial picture, including investing, retirement planning, estate planning, and protection planning. Unlike other financial advisors, a financial planner looks at your finances as an interrelated whole and helps you plan accordingly. Because anyone can call himself or herself a financial planner without being educated or licensed in the area, you should choose a financial planner carefully. Make sure you understand the kind of services the planner will provide you and what his or her qualifications are. Look for a financial planner with one or more of the following credentials:
Financial planners can be either fee based or commission based, so make sure you understand how a planner is compensated. As with any investment advisor, it's your responsibility to ensure that the person you're considering is competent to handle your hard-earned money.
The 360 Degrees of Financial Literacy Web site offers general information for managing personal finances and does not recommend specific financial actions. For financial advice tailored to your situation, please contact an expert such as a CPA or a personal financial advisor.