Portfolio Basics
Strategy, Diversification and Risk Management
It could be an artist’s collection of drawings or photographs; it could be a flexible case for carrying papers; or, it could be the key to sending your kids to college and retiring comfortably. Portfolios can be many things, but in investing terms, a portfolio is the collection of financial assets such as securities, bonds and funds that are held by an investor, often for achieving long-term financial goals.
Strategic Planning
When an artist puts together a portfolio, he chooses the pieces carefully to meet a particular objective. For example, if his goal is to earn a prominent gallery placement in New York, he will select photographs for his portfolio that match the tastes of the gallery’s clientele and are likely to help him achieve his goal of being selected by the gallery.
Likewise, investors carefully choose financial assets to help them achieve an objective. Rather than taking existing investments and lumping them together into a grouping called “portfolio,” investors begin with a goal and then fill their portfolio with strategic investments that are designed to meet that goal.
For example, a conservative investor putting together a portfolio designed to support her during retirement might choose large cap stocks and secure bonds, while a less risk-averse investor might choose more volatile stocks and try to balance them with equally volatile stocks in an opposing industry. The investments that make up any portfolio depend on the goals and risk tolerance of the individual investor.
Diversification
The ideal investment would be one with low risk and high returns, but those opportunities are rare. Thus, many portfolio investors combine several different investments with varying levels of risk and return to balance each other out. This is called diversification. The idea behind diversification is that the positive performance of some investments will neutralize the negative performance of others, which smoothes out risk and protects the investment portfolio as a whole.
A simple example of diversifying investments would be to buy stock in green energy and in oil. It’s likely that one or the other will be the primary source of energy in the U.S., and one will likely be up while the other is down. The fluctuations of a single security should have less impact on a diverse portfolio, and diversification minimizes the risk of investing in only one of the energy stocks.
Risk Management
Because minimizing risk is one of the key goals of portfolio management, it’s important to understand what types of risks investors are up against. There are two primary types of risk for individual stocks:
Systematic Risk – This is market risk that is universal and isn’t specifically linked to a particular stock. Examples include, war, recession and interest rates – anything that results in general market moves.
Unsystematic Risk – This is a risk that is specific to individual stocks and can be mitigated through diversification. Unsystematic risks are not correlated to general market moves. For example, with the oil stock above, if there is a major breakthrough in green energy and the United States stops buying oil, the economy in general might go up, but the oil stock would go down.
Some experts say a well-diversified portfolio of 25 to 30 stocks is the most cost-effective way to minimize risk – any fewer and the risk is still too high; any more and the diversification benefits still increase, but at a much lower rate.
