How you can build an investment portfolio
When it comes to building an investment portfolio there are a few golden rules: know what you want to achieve; research thoroughly before committing any money; and avoid the temptation to risk every penny on just one area of the market.
If the past few years have taught us anything it's that there are no guarantees of investment success, so ensuring you have a diversified spread of assets is essential to reduce your overall level of risk. A well constructed portfolio should be diversified in a variety of ways, including overall investment style, number of individual asset classes, spread of geographical allocation and the approach of the fund manager.
Step one: Understand risk
Most portfolios will include equities, cash and fixed interest investments, such as corporate bonds and gilts, but how you divvy up your money between these asset classes will depend on your financial goals and willingness to accept losses. So the first step is to ascertain if you are a low, medium or high-risk investor.
Lower-risk investors prefer to put their money into safer investments, favouring cash and fixed-interest because they are more concerned about losing their money than making huge returns. This approach is often favoured by people who don't have time to recoup big losses, perhaps those in, or approaching retirement.
Medium-risk investors accept more risks must be taken to generate better returns and are happier to invest more in equities. However, they would not feel comfortable ploughing all their money into stocks and shares. This approach is sensible for those who can ride out the high and lows of stockmarket investing.
Higher-risk investors will include some more speculative investments in their portfolio, such as emerging markets or smaller companies, in the hope of generating stellar returns. This is only suited to those investors who can afford to ride out big losses.
Step two: Know your type
Your long-term goals will determine your investment style. If you're looking for regular returns in the form of dividends, for example, you want to boost your income in retirement, investing for income makes sense.
If you have years to save, investing for growth might be more suitable as you will focus on companies whose profits and share prices are likely to dramatically outperform the stockmarket over the next few years. As part of a diversified approach, it's advisable to have a mix of both strategies within your overall portfolio.
If you're more cautious, a higher weighting in incomegenerating funds would be sensible, whereas the gung ho would have more in growth-focused funds.
Step three: Diversify
Wealthy or hobbyist investors may choose to buy individual corporate bonds or shares but it usually makes most sense to invest in collective investment funds, where money from numerous investors is pooled and invested by a professional fund manager. Investors in these funds benefit not only from increased diversification but also economies of scale, effectively reducing both the trading costs and potential risks.
Pooled investments, like open-ended investment companies (OEICs) and investment trusts, can invest in a variety of asset classes, but the four main ones are equities, bonds, property and cash.
Whatever type of investor you are, diversification is key. Different asset classes won't generally rise and fall at the same time so having a broad spread means you are building an element of protection into your portfolio to safeguard you against tougher environments.
For example, if you're getting little return from corporate bonds, you would hope the equities you'd chosen would be rising in value. When commodities are doing well, property may be struggling. It's all about striking a balance between asset classes so that one is always on the up.
Step four: Choose your funds
Once your asset allocation is decided it's time to choose your funds. It might be tempting as a UK-based investor to concentrate all your efforts on funds investing in what are perceived to be UK companies but this might not be sensible. In fact, given the current climate, you may well be advised to include some international exposure.
Although funds investing in regions such as Latin America and Asia have done well in recent years they are higher risk and it may be more sensible to pick a fund that invests across the globe. Managers here will give you some exposure to those economies but won't bet your shirt on them. You also need to be confident your chosen fund manager can make you decent returns, but finding one that can perform consistently well can be a challenge.
A good performance track record is no guarantee of future success but looking at performance over several time frames such as three, five and seven years can show how they have performed in different market conditions. Try to seek out funds that are consistently top-quartile, meaning they are always in the top 25% when compared with other funds in their sector.
You should also find out about the fund manager's objectives and investment approaches, and see if you can find out key information such as whether they invest their own money in the fund. Those that do, of course, have a vested interest in its success.
Much of this information is available from fund supermarkets such as Interactive Investor and Funds Network. You can use fund search tools to find ones to suit your criteria, compare past performance and get the lowdown on individual funds by downloading fund fact sheets.
Step five: Monitor your decisions
The process of building a portfolio mustn't end when you’ve invested your cash. To get the best from your investments you need to regularly review them, so read monthly updates from managers and do a proper review every six months.
You shouldn't automatically ditch fund managers as soon as returns fall but it's useful to see if they have a justifiable reason for periods of poor performance. If a fund consistently underperforms its peers you may decide to switch.
The alternative method of portfolio construction
Finally, for investors that want a diversified exposure to a variety of fund managers and regions of the world, but are unwilling or lack confidence to do it themselves, an alternative option is investing in a multi-manager fund.
Here, fund managers buy into other funds rather than individual companies in the hope that getting access to a wider range of fund management talent will result in better returns, increased diversification and lower risk.
However, there is a price to pay. In the vast majority of cases these funds will cost substantially more than ordinary funds because you have to pay fees, not just to the manager running the fund but all the managers running its holdings. The fund would need to out perform strongly to justify this decision.
Golden rules of portfolio building
- Consider your objectives. Savings are for the short term, investing is for the long term.
- Accept that the value of your investments will rise and fall.
- Remember risk and return are closely linked.
- Ensure your investments reflect your goals and attitude to risk.
- Review your portfolio every six months.
- Be too cautious. Accepting a degree of volatility is key to generating long-term returns.
- Be distracted by noise. It's impossible to judge short-term market movements but don't let this put you off.
- Chase performance. Most investors go for the flavour of the month but look at funds with the potential for steady growth year after year.
- Pull out if the going gets tough. Selling after a downturn is a sure way to lose money.
Open-ended investment companies are hybrid investment funds that have some of the features of an investment trust and some of a unit trust. Like an investment trust, an Oeic issues shares but, unlike an investment trust which has a fixed number of shares in issue, like a unit trust, the fund manager of an Oeic can create and redeem (buy back and cancel) shares subject to demand, so new shares are created for investors who want to buy and the Oeic buys back shares from investors who want to sell. Also, Oeic pricing is easier to understand than unit trusts as Oeics only have one price to buy or sell (unit trusts have one price to buy the unit and another lower price when selling it back to the fund).
All investment returns are measured against a benchmark to represent “the market” and an investment that performs better than the benchmark is said to have outperformed the market. An active managed fund will seek to outperform a relevant index through superior selection of investments (unlike a tracker fund which can never outperform the market). Outperform is also an investment analyst’s recommendation, meaning that a specific share is expected to perform better than its peers in the market.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
A term applied to raw materials (gold, oil) and foodstuffs (wheat, pork bellies) traded on exchanges throughout the world. Since no one really wants to transport all those heavy materials, what is actually traded are commodities futures contracts or options. These are agreements to buy or sell at an agreed price on a specific date. Because commodity prices are volatile, investing in futures is certainly not for the casual investor.