Do you think that an “investment portfolio” is an abstract concept referring to any set of assets a trader or investor works with? In reality, creating an investment portfolio involves a clear, structured approach.

Diversification of an investment portfolio is a fundamental principle of successful investing. It helps reduce risks associated with price fluctuations of individual financial instruments and increases the stability of returns. Combining short-term and long-term investment goals in one portfolio can present certain challenges.

Creating an effective investment portfolio requires a comprehensive approach that considers both the investor’s individual financial goals and the current market situation.

ParadTrade answers the key questions about portfolio creation and diversification.

What is an investment portfolio?

An investment portfolio is a collection of various financial instruments acquired by an investor to generate profit. This could range from a single security to a diverse set of assets spread across different classes.

The assets in an investment portfolio can vary greatly: from traditional ones like stocks and real estate to more exotic options such as cryptocurrencies or art. The choice of specific assets depends on the investor’s goals, risk profile, and financial situation.

An investment portfolio can include different types of accounts, such as brokerage accounts, pension funds, and others. Each account type has its own tax implications and limitations, which must be considered when forming a portfolio.

A key principle of investing is diversification, which means spreading investments across different assets. This allows for risk management, as it mitigates the effects of price fluctuations in a specific market or sector. However, it’s important to remember that diversification doesn’t guarantee profits or eliminate the possibility of losses.

What is diversification?

Investment diversification is a strategy of distributing capital across various financial instruments, industries, and geographic regions to reduce the overall risk of the portfolio. The idea is that the negative performance of one asset can be offset by the positive dynamics of another, ensuring more stable and predictable overall returns.

A key principle of diversification is forming a portfolio from assets that have minimal correlation. For example, if an entire portfolio consists of airline stocks, any negative event affecting the aviation industry (like a prolonged strike) will significantly reduce the portfolio’s value. Including railway stocks in the portfolio can mitigate this risk, as demand for rail travel typically increases when flights are canceled.

Thus, diversification implies creating a balanced portfolio where different assets compensate for each other during periods of market instability. Instead of aiming for maximum short-term profit, an investor who follows the diversification strategy prioritizes long-term stability and risk reduction.

In essence, diversification acts as a form of insurance against unforeseen circumstances, allowing the investor to remain calm even during periods of heightened market volatility.

Why is diversification important?

Diversification is a strategy aimed at reducing the risk of capital loss. It is particularly relevant for mature investors who want to preserve their accumulated wealth, for example, to ensure a comfortable retirement. For retirees and those nearing retirement, diversification is especially important because their income becomes less stable, and their investment portfolio often serves as the primary source of funds for meeting current needs. In such cases, capital preservation takes precedence over maximizing returns.

It is believed that diversification enhances a portfolio’s risk-adjusted return. This means the investor achieves higher returns relative to the risk taken. Although riskier investments may yield greater profits, risk-adjusted return is a more objective measure of the effectiveness of invested capital.

Beyond reducing risks, diversification opens up new opportunities for investors. For instance, if an investor diversifies their portfolio by investing in a streaming service company that signs a major partnership or announces significant content investments, their returns could increase substantially. Thus, diversification helps investors seize potential opportunities across various industries. Additionally, diversification can make investing more engaging, as it involves exploring different sectors, comparing companies, and making decisions about investment allocation.

What types of diversification exist?

  1. Sector and Industry Diversification: A classic example is purchasing railway company stocks to reduce risks associated with airline company investments. This approach lowers the portfolio’s vulnerability to sector-specific crises since different industries respond differently to economic cycles. However, even within one sector, risks may arise from broader macroeconomic factors (e.g., a drop in consumer activity could negatively affect both air and rail transportation).
  2. Company Diversification: Risks may be specific not only to sectors but also to individual companies. For example, a leadership change or reputational risks could negatively affect a company’s stock price. Therefore, even when investing in one industry, it’s advisable to spread funds across several companies to mitigate these company-specific risks.
  3. Asset Class Diversification: Stocks, fiat currency, cryptocurrency, commodities—all these assets behave differently depending on economic conditions. For instance, when interest rates decrease, currency values typically drop, while stocks may rise. Diversifying between asset classes reduces the impact of overall market risks and creates a more balanced portfolio.
  4. Geographic Diversification: Political, economic, and social events in different countries can significantly affect investments. Distributing assets across various geographic regions reduces risks related to political instability, tax law changes, and other country-specific factors.
  5. Diversification through Alternative Assets: Modern investors can diversify their portfolios using alternative assets such as cryptocurrencies, real estate, art, and others. These assets often have unique characteristics and offer new income opportunities.

How to create an investment portfolio?

Building an effective investment portfolio requires a structured approach based on a sequential series of actions. Each step in this process plays a key role, ensuring a logical relationship between individual elements of the portfolio and contributing to the achievement of the set financial goals.

The primary task of an investor is to define their investment goals and the corresponding time horizons. A clear understanding of why the portfolio is being formed and when the invested funds will be needed allows you to choose the best financial instruments and asset management strategies. Depending on the time frame for achieving the goals, investment horizons can be short-term (up to one year), medium-term (from one to five years) or long-term (more than five years). For example, saving for retirement and buying a car at the same time implies both long-term and short-term investment goals.

Building an investment portfolio is inextricably linked with assessing individual risk appetite. By defining the time horizons for each financial goal, an investor can more accurately assess the degree of risk he or she is willing to accept to achieve these goals. The length of the investment horizon directly affects the level of acceptable risk.

The more distant the goal, the more aggressive the investor can choose an investment strategy, since he will have enough time to compensate for potential short-term losses. On the contrary, for short-term goals, a more conservative approach is usually recommended, since the investor most likely cannot afford to lose a significant part of the savings.

Risk appetite and time horizon are interrelated concepts. Insufficient risk appetite in long-term investing can lead to failure to achieve financial goals. On the other hand, excessive aggressiveness in short-term investing can lead to capital loss in the event of unfavorable market conditions.

The choice of investment account is directly related to the definition of financial goals and investment horizons. Each type of account has its own unique characteristics that make it most suitable for specific tasks.

Tax-advantaged accounts, such as Individual Retirement Accounts (IRAs) and similar instruments in other jurisdictions, are ideal for long-term investing, especially for retirement savings. The flexibility of these accounts allows for a wide range of investment vehicles, making them suitable for investors with varying levels of risk tolerance.

Taxable brokerage accounts generally provide a wider range of investment options than tax-advantaged accounts. They are particularly well suited for medium – and long-term goals where the investor is seeking higher returns than traditional bank deposits can provide.

Building an investment portfolio involves not only choosing specific financial instruments, but also determining the optimal balance between different asset classes. This process, known as asset allocation, helps reduce risk and increase potential investment returns.

Asset allocation is all about diversifying an investment portfolio. Instead of investing all of your funds in one asset class, you distribute them across different asset classes. This approach helps reduce the impact of negative factors that may affect individual market segments.

The choice of optimal asset allocation depends on a number of factors, including investment goals, investment horizon, and risk tolerance. For example, an investor with a long-term horizon and high risk tolerance may benefit from a portfolio dominated by stocks, while a conservative investor with short-term goals may benefit from a portfolio dominated by cash.

Once the overall asset allocation has been determined, it is necessary to move on to diversification within each class. For example, the stock portion of the portfolio can be diversified by industry, region, and company size. This helps reduce the risk associated with investing in individual companies or sectors of the economy.

To facilitate the process of forming an investment portfolio, many investors use ready-made asset allocation models. These models allow you to quickly assess the optimal ratio of different asset classes depending on the individual characteristics of the investor. However, it should be remembered that each investment situation is unique, and the final decision always remains with the investor.

But remember: building an investment portfolio is just the beginning of a long-term process. To ensure that it generates a stable income and meets your financial goals, it is necessary to regularly monitor it and make adjustments.

Periodic portfolio rebalancing is an important element of an investment strategy. It allows you to maintain the desired balance of different assets and minimize the risks associated with market fluctuations. The optimal frequency of rebalancing depends on the individual characteristics of the portfolio and can vary from once a year to several times a quarter.

As life circumstances change, such as getting married, having a child, changing jobs, or approaching retirement, so may your investment goals. In such cases, it is necessary to review the investment strategy and make appropriate adjustments to the portfolio.

What is asset allocation?

Asset allocation is the strategy of distributing capital across different asset classes to reduce risk and optimize returns. Essentially, it’s the process of creating a portfolio that best suits your individual investment goals, comfort with risk, and expected returns.

At its core, diversification follows the principle: don’t put all your eggs in one basket. By spreading investments between stocks, bonds, and other financial instruments, the investor seeks to minimize the impact of market fluctuations on a single asset within the entire portfolio.

There are many options for creating an investment portfolio, from conservative ones aimed at preserving capital to aggressive ones that involve high risks but also potentially high returns. However, before you start investing, it is important to create a financial safety cushion that will help you survive unexpected expenses.

After creating a portfolio, it is necessary to regularly rebalance it, that is, return the shares of various assets to their original values. This will allow you to maintain the desired level of risk and return of the portfolio in the long term.

How to choose assets?

Assets can be divided into several main categories, each with its own unique characteristics. Traditionally, three main classes are distinguished: stocks, funds, and alternative investments.

Stocks provide the investor with ownership in a company. By purchasing stocks, the investor becomes a shareholder and has the right to receive a portion of the company’s profits in the form of dividends. Stocks are traded on stock exchanges, which ensures their liquidity.

Exchange-Traded Funds (ETFs) and mutual funds allow for portfolio diversification by investing in a basket of securities. This is a simpler and more accessible way to diversify than selecting individual assets independently.

Alternative investments encompass a wide range of assets not related to traditional classes. These include precious metals, real estate, cryptocurrencies, artwork, and more. Alternative investments are often characterized by higher returns but also come with higher risks. The choice of asset class depends on the investor’s financial goals, risk tolerance, and investment horizon.

What else should be considered when creating a trader’s portfolio?

Strategic rebalancing of the investment portfolio is the process of regularly returning the proportions of different assets in the portfolio to their original target allocations. As market conditions change, the balance of assets may shift from the initial plan. Rebalancing helps maintain the desired level of risk and return in the portfolio.

The rebalancing process involves selling overvalued assets (those whose share in the portfolio has exceeded the target) and buying undervalued assets. For example, if the share of growth stocks in the portfolio has significantly increased due to their rise, you might sell some of these stocks and invest the proceeds in other assets whose share in the portfolio has decreased.

When making decisions about rebalancing, the following factors should be considered:

  • Tax consequences: Selling assets can trigger tax liabilities. Therefore, it’s advisable to consult with a tax advisor before deciding to sell.
  • Market outlook: It is important to evaluate whether the current market trend will continue or if a change is expected. If the value of an asset is expected to decrease, selling it might be justified.
  • Risk tolerance: The investor needs to determine how much risk they are willing to accept. This will affect the choice of assets and the frequency of portfolio rebalancing.

A financial advisor can help an investor identify their financial goals, risk tolerance, and create an optimal investment portfolio. These specialists will also regularly monitor the portfolio and make necessary adjustments.