Now that you have understood the science of diversification, this article will explain how to put these principles into practice by explaining how to build an investment portfolio.
If you have read the previous articles, the following steps should feel like common sense. Indeed this article threads together many of the concepts from the Foundation learning series.
Step 1: Understand your time horizon
Review your personal circumstances and decide how long you will be able to tie up your funds in investments. Consult against the guidelines provided in our earlier article ‘What is an investment time horizon‘, to discover whether any investment classes, such as equities, are not appropriate for a period as short as yours.
Step 2: Understand your risk profile
Our ‘Attitude to risk questionnaire‘ will indicate whether you have the tolerance which suits high-risk investments or whether you would be more comfortable with a lower risk portfolio. You will live with your portfolio for many years, therefore it’s important that you are compatible with it.
Step 3: Choose a high-level asset allocation
A portfolio doesn’t need 5 different asset classes to be useful. Many investors opt for the following example allocations as a starting point:
Example Asset Allocation: Adventurous Investor
- 80% Equities | 20% Bonds
- 60% Equities | 20% Property | 20% Bonds
- 60% Equities | 15% Property | 15% Bonds | 10% Cash
Example Asset Allocation: Balanced Investor
- 60% Equities | 40% Bonds
- 45% Equities | 10% Property | 40% Bonds
- 45% Equities | 10% Property | 30% Bonds | 10% Cash
Example Asset Allocation: Cautious Investor
- 40% Equities | 60% Bonds
- 27.5% Equities | 7.5% Property | 70% Bonds
- 25% Equities | 5% Property | 50% Bonds | 20% Cash
Example Asset Allocation: Risk Adverse
- 20% Equities | 80% Bonds
- 10% Equities | 10% Property | 50% Bonds | 30% Cash
These are completely flexible and can be tailored to your preferences. The principle driving how I have mapped these to the different profiles, is that the higher the equity proportion, the higher the risk. The higher the bond & cash proportion, the lower the risk.
Step 3 minimises the systematic risk experienced by your portfolio as a whole.
Step 4: Choose a sub-asset class allocation
Create a detailed list of what asset sub-classes you want to hold in your asset classes. Refer to the table in the earlier section for sub-class examples.
This step is just as important as step 3. A 40% allocation to ‘equities’ could generate more risk than a 60% allocation to equities if the sub-asset classes chosen were inherently riskier (such as emerging markets equities).
Therefore, consideration of your risk profile is needed when determining how to sub-allocate. We will use the example of equities to show different risk levels:
Sub-Allocation of Equities: Adventurous Investor
- 30% UK Large Cap*, 20% UK Small Cap*, 30% Worldwide**, 20% Emerging Markets
Sub-Allocation of Equities: Balanced Investor
- 50% UK Large Cap, 10% UK Small Cap, 30% Worldwide, 10% Emerging Markets
Sub-Allocation of Equities: Cautious Investor
- 70% UK Large Cap, 20% UK Small Cap, 30% Worldwide
Sub-Allocation of Equities: Risk Adverse
- 70% UK Large Cap, 30% Worldwide
*Large cap is short for large market capitalisation (i.e. company value), therefore refers to the FTSE 100 index of companies. Whereas Small cap refers to small companies which form the FTSE 250 index of companies.
**Worldwide refers to large cap companies in developed countries, excluding the UK.
As the risk levels reduce, the proportion of weighting to UK increases (given that the UK is a relatively stable country relative to the average, and this reduces foreign currency risk). Exposure to emerging markets and smaller listed companies reduce as these are the higher risk equity categories.
For corporate bonds, higher risk portfolios may include ‘junk bonds’ (bonds with lower credit ratings and therefore higher yields) and corporate bonds from emerging markets. More cautious portfolios will give a higher weighting to government bonds and high-grade corporate bonds.
Choosing your sub-asset allocation is the most difficult and judgemental aspect of how to build an investment portfolio. Therefore, please take your time at this stage to conduct thorough research.
Step 5: Choose an investing method – Funds versus individual holdings
Our article ‘How to invest in shares and the stock market‘ lists the pros and cons of each investment approach. You will not be able to choose a useful stockbroker or investment service without first understanding your needs.
Step 6: Choose a stockbroker or investment service
This is a difficult step due to the massive choice between different providers offering different services and charging different fees. Examples of popular stockbrokers include Vanguard, Hargreaves Lansdown, Interactive Investor and Halifax.
Step 7: Pick a fund or research individual companies within each sub-asset class.
At Financial Expert, we enthusiastically recommend taking the fund route over individual shares.
The reasons include; lower cost, ease & convenience, instant diversification, and access to some investments that would be otherwise very difficult to access as a retail investor.
Vanguard offers a range of funds with low management charges (less than 0.3% per year) in most common sub-asset classes. I personally use Vanguard. Here are some equity funds offered by Vanguard that match up to the sub-classes discussed above, and which all contain over 20 holdings.
I encourage you to look research Vanguard and their funds before you look elsewhere so that at least you have their funds as a strong comparison and benchmark.
Picking specific funds is a huge topic which we cannot hope to cover in this overview article. Please explore our other Foundation and Intermediate topics for further information.
Step 8: Deposit funds and invest!
The final exciting step is to transfer money into your investment platform from your bank account to begin your investing journey.
Our article ‘How to invest in shares and the stock market‘ takes you step by step through the information you will need to execute a share purchase. Buying funds is even more straight forward.
Now you’ve read these 8 steps, you will now understand how to build an investment portfolio! If you have landed on this article, please ensure you check out all the Foundation level articles on this topic.
Intermediate level is designed to elevate your core knowledge and enhance your investing strategy to increase returns. Begin your journey in this series or upgrade to a more advanced level
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