Investing Part Two: Building Your Portfolio
Episode #9 of the course Personal financial literacy: Take control of your future by Riley Burger
As discussed in the last lesson on asset classes, investing should be a key part of most people’s financial toolkits. Investing gives you the opportunity to grow your wealth, support companies, industries, and localities you believe in, and accomplish your future financial goals!
Today we are tackling two concepts: planning your investment portfolio and putting it to work.
There are two main concepts to take into account when creating your portfolio: risk and return.
Money in a checking account generally only carries one type of risk: inflation risk. That is the possibility that the purchasing power of your saved money will decrease as inflation goes up.
Investing subjects your money to many other risks, and it is up to you to determine your risk tolerance, or how comfortable you are with losing money in the event the value of your investment goes down.
Types of risks can be broken into two groups: systemic and idiosyncratic. Systemic risks are risks that the entire market is exposed to (recessions, global events, etc). Idiosyncratic risks are risks that are company, industry, or asset-specific, and include the following, among others:
• Equity risk: risk of a decrease in the value of stock due to a change in supply or demand.
• Default risk: Risk of a company losing value or even going bankrupt and becoming unable to repay its debts, particularly relevant for bondholders.
• Interest rate risk: Applies primarily to bonds, and is the risk that the value of your bond will decrease if interest rates increase.
• Liquidity risk: Risk that you may not be able to sell your asset at a fair price, or in a timely manner. For example, a house (a real asset) that you own has low liquidity; it takes a long time to sell. Savings accounts, on the other hand, have high liquidity; you can remove your money almost instantly.
• Currency/foreign investment risk: Applies for investments in foreign markets, where your investments are subject to changing values of foreign currencies, as well as changes in economic conditions and financial regulations in other countries.
When choosing investment assets, it is important to find out what risks they are exposed to, as well as how they have performed in periods of economic stress like recessions. It is also important to think of your personal risks, like:
• Horizon risk: Risk that your investment horizon may need to be shortened due to an unforeseen circumstance (what if you have a large medical expense in ten years? Will you be comfortable pulling your money out of the market to cover the expense, potentially causing capital losses?)
• Concentration risk: Risk of your portfolio being disproportionately affected by losses in a particular industry or asset class. This can be mitigated by diversification.
The fun stuff! The primary goal of the investment is obviously to grow your wealth. In investing, you deal with the risk-return tradeoff: generally, with higher returns, comes higher risk. It’s important to take your personal financial goals and investing horizon into account here.
Most portfolios will be primarily stocks and fixed income, with a small number of alternative investments. Stocks generally have higher risk and return than fixed income products.
Try placing yourself somewhere between these three hypothetical scenarios:
• Are you 25, with an investment horizon of 40 years and an appetite for risk? You may be able to invest up to 80% of your money in stocks, 20% in fixed income.
• Are you 45, with an investment horizon of 30 years, and with children and other responsibilities to include in your financial plan? You may want to try a traditional 60% stocks, 40% fixed income split.
• Are you 65, about to retire, risk-averse, and focused more on not losing your hard-earned savings rather than gaining ultra-high returns? You may want to go as far as 20% stocks, 80% fixed income.
If you are somewhere in-between, your portfolio could be in-between to match, and then you can change your allocations as you assess your own reaction to the risks and returns that you see.
How to set up an investment account
So, how do you actually get started?
Step One. Most importantly, don’t invest more than you’re willing to lose!
No investment is risk-free. When starting out, only put in an amount of money that you don’t need immediately and wouldn’t be a threat to your lifestyle if you lost. When I started, I put in $300.
Step Two. Sign up for an investment account.
Many self-directed investment platforms offer free or almost-free trading. Look for a platform that offers the investment options, guidance, and interface that is best for you. There are platforms out there that will let you get nitty-gritty with graphs and charts and financial analysis, and there are also platforms with simple interfaces and easy-to-follow data visualizations of your performance.
Step Three. Pay attention to percentage gains/losses, not dollar amounts.
Especially when starting out, it can be easy to get discouraged with slow growth in your investment account. But if you focus on percent growth or loss, and keep adding a bit of money from each paycheck, that can lead to incredible long-term growth!
Step Four. Do your due diligence.
It’s important to analyze the company’s current and historical performance. Financial statements, Letters to Shareholders, and news articles can be great resources for your research.
Step Five. Know the tax implications of capital gains and losses.
In general, short-term capital gains (if you sell the asset less than a year after you buy it) are taxed as regular income, and long-term capital gains (sold more than a year after purchase) are taxed at a slightly lower rate. Capital gains tax law changes often, so make sure you stay updated.
For our last lesson, we’ll be looking at summarized checklists for building your financial foundation, as well as additional resources for continued learning!
Investopedia has a great guide to capital gains and losses here.
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