8) Investing 101: Portfolios and Diversification

by · August 24, 2010

It is essential that one know how securities are different from each other, but a more important thing is understanding how its different characteristics work as a whole to accomplish a goal.

The Portfolio

Portfolios are a mixture of different investment assets cris-crossed for the purpose of achieving the investor’s goals.A portfolio may include items one owns like art, real estate, equities, and fixed-income instruments. for this article, we will discuss only the most liquid types of assets: fixed-income, equities, and cash and equivalents.

To better understand a portfolio, think of a chart. Each slice represents a certain allocation which together forms the whole portfolio. The risk and expected return of this portfolio is determined according to the asset mix you choose as befits your goal.

Basic types of portfolios

Aggressive investment strategies: most appropriate for investors with high risk tolerance. This type of portfolio are for those who want the highest possible return and have a longer time horizon.

Conservative Investment Strategies: this type is for investors who are risk averse . Unlike the first type, safety is high priority. This is for investors who have a shorter time horizon and generally consists of cash and cash equivalents, or high-quality fixed-income investments.

Now we look at examples of conservative and moderately aggressive portfolios:

Of note, any short-term, fixed income investment is referred to as the money market and cash. Example of these are money in savings account and certificate of deposit or COD.

The objective of a conservative portfolio is protecting the value against inflation, i.e, maintaining the real value of the portfolio. In this diagram, you will see a high amount of current income from the bonds which would also produce long term capital growth potential from the investment in high quality equities.

In the moderately aggressive portfolio, investors want balance between the amount of risk and return within the fund. This portfolio would be 50-55% equities, 35-40% bonds, and 5-10% cash and equivalents. These classes can then be further subdivided into subclasses with different risks and returns. An example of this is dividing the equity portion between large companies, small companies, and international firms. Other investors can opt for alternative assets like options and futures.

Why Portfolios?

Portfolios offer diversification. Simply put, different securities perform differently at any point in time, it avoids the risk of having an entire portfolio collapse if a security declines. In other words, it does not put all eggs into one basket. This reduce the risk of a catastrophic financial loss.