A lot of new investors doesn’t have any clue about managing their investment portfolio. Often times, many of them are not really aware of the risks they are exposed into. They know the word ‘diversification’ but doesn’t really understand how diversification works and how it is applied. If you are an investor who wants to learn the basic of portfolio management then let me share to you this quick guide of mine.
There are many advantages of this strategy in investing but here are the two most important to me:
- Doing this would mean balancing the risks against the performance of your investments in order for you to protect your capital while minimizing your losses.
- Doing this would align your investments according to your risk tolerance and goals in investing as you age.
A little disclaimer : this is for the financial markets, I didn’t include real estate investments.
Okay so lets start , first is you have to…
Know your risk tolerance
Here are 10 questions to know your risk tolerance in investments. Click here to know.
Now that you know of what type of an investor you are, here are the guidelines in partitioning your portfolio.
If you fell into the conservative investor profile, your portfolio would be 90% liquidity and 10% growth.
If you fell into the cautious investor profile, your portfolio would be 80% liquidity and 20% growth.
If you fell into the prudent investor profile, your portfolio would be 40% liquidity and 60% growth.
If you fell into the assertive investor profile, your portfolio would be 20% liquidity and 80% growth.
If you fell into the aggressive investor profile, your portfolio would be 10% liquidity and 90% growth.
Let me define two terms Liquidity and Growth:
- Liquidity – this means that the investments you would be participating in should be easy to withdraw, earns you fixed interests, and preserve your capital.Examples are time deposits, treasury bills, bonds, notes, uitf/mutual funds that are invested in money market funds or bond funds, and the like.
- Growth – this type of investments earns you by capital appreciation, and multiply your capital in the long term. They may be more riskier and more volatile but the returns would be higher as well.Examples are stocks, uitf/mutual funds that are invested in equities, forex, or derivatives.
Again, these are just guidelines in partitioning your portfolio, these guidelines are based on your answers in the questionnaire that may best align to your perspectives/personality towards risks.
If you are not comfortable with your results and with the partitioning you can always adjust it depending on your conviction on what really suits you.
Lets have an example, let us say that you fell into the prudent investor profile.
Your budget for investments is 10,000 pesos a month. Since the partitioning will be 40% liquidity and 60% growth, you now divide your 10,000 into 4,000 and 6,000 respectively.
We will invest the 4,000 in a bonds fund and 6,000 in stocks.
After 2 years, the total amount of money we invested is 240,000 pesos (10,000 x 24 months)
Our total investments in the bonds fund would be 96,000 pesos (4,000 x 24 months) and 144,000 pesos (6000 x 24 months) in our stocks.
Within that 2 years, the market has moved.
And now, our investments in bonds fund values at 104,025 pesos (+8.36%) and our investments in stocks values at 120,250 pesos(-16.49%).
We paper gained in our bond fund and we paper lost in our stocks.
So how did our total portfolio performed?
Total current value after 2 years is 224,275(-6.55%) pesos over total invested money of 240,000 pesos.
Since we have diversified our portfolio, our losses in the stocks haven’t affected our capital that much because of the gains that we had in our bonds fund. We have spread the risks and minimized our losses.
Diversification works this way and it is applied by investing in different asset classes. A bond fund is an interest type(fixed) of investment and stocks is a capital appreciation(variable) type of investment.
The essence of diversification is to invest in asset classes that don’t rise and fall together.
There will be instances that they will but not on most cases.
It doesn’t make sense when someone invests in let say BPI equity uitf, BDO equity uitf, PNB equity uitf. Technically, it is diversifying because these banks have different fund managers but practically speaking, this is not what diversification really means because once that a global crisis hit the investments, all of them will lose their value together and there is no asset class to negate the losses.
Continuing with our example..
Let us say that after 2 years we had a different scenario.
Our investments in the bonds fund still values at 104,025 pesos(+8.36%) but this time our stocks value at 182,120 pesos(+26.47%).
This time the market has favored our stocks to the upside.
We paper gained in our bond fund and we paper gained in our stocks as well.
So how did our total portfolio performed?
Total current value after 2 years is 286,145 pesos (+17.27%) pesos over total invested money of 240,000 pesos.
Since we have diversified our portfolio, our gains in stocks has been minimized as well because the gains in our bonds fund is lesser.
Diversification minimizes our losses and in the same effect minimizes our gains as well.
But here’s the thing,
If you would ask me, it is really a win-win because minimizing the losses is a great thing and even if the gains are also minimized, it is still a GAIN!
As long as it grows I’m good with it.
Now the next step is to…
Rebalance your portfolio on a regular basis
In our last example.
Our investments in the bonds fund valued at 104,025 pesos(+8.36%) and our stocks valued at 182,120 pesos(+26.47%).
If you would notice the 60/40 partitioning doesn’t apply here.
The total value of our portfolio is 286,145 pesos and 104,025 pesos isn’t 40% of the portfolio anymore same with the 182,120 pesos.
The 40% of 286,145 pesos is 114,458 pesos and the 60% is 171,687 pesos.
This means that our exposure to the risks of stocks is higher. There is a need to re-balance so that you will maintain only a 60% exposure to the risks of stocks. There is a need to lock-in the profit of our stocks and transfer it to our bonds fund.
We can withdraw(profit lock) 10,433 pesos from our stocks investment and transfer it to our bonds fund to maintain the 60% exposure to the risks of stocks(keep it safe).
By re-balancing our portfolio, we protect our gains and minimize our exposure to risks.
If the scenario would be that the stocks investment is negative and the bonds fund is positive, then re-balancing it would compensate the stocks which is the laggard in that scenario. Over the long run…
Even if the markets are volatile, doing re-balancing will protect our portfolio and make it perform better over time.
Re-balancing can be done once or twice a year.
The last step in this guide to portfolio management is going back to step one which is to know your risk tolerance. As we age in life our risk tolerances change.
In our 20’s, the aggressive type of investor may work for us because we don’t have much responsibilities yet and we have a lot of time to grow our money but as we age and reach our 30’s or 40’s, the responsibilities come and that affects our decision making.
The most common practice is; as we age, we should incline our investments to the more conservative type because..
You will retire depending on the markets if you haven’t put it in the safer investments. If the market is down by the time you retire, then pick another year of retiring(joke).
We should also be wise to protect the money we’ve grown when we were young so that we can fully enjoy it when we get old.
I hope that this guide will help you better your investments because at the end of the day we just wanted to pursue happiness(and use the money we’ve grown haha). Kidding aside, if you want more of these then go and subscribe to my blog The Frugal Worker by entering your email below this post. Don’t worry your details are safe and confidential, this is for the sake of updating you when I have a new post in my blog.
Let me know your thoughts in the comments section.
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To your success,
Photo Credits : Seth Sawyers