A portfolio is one of the basic concepts while investing and in finance. The term can have a variety of meanings depending on the context. However, the simplest meaning of a portfolio is a collection of assets owned by an investor. Basically, it includes every asset that can grow in value or provide returns to the investor.
What is Portfolio?
A portfolio is a collection of different financial assets like stocks, bonds, commodities, cash, real estate, etc. Any investor can hold a portfolio like an individual, corporation or financial institution. Investors put their money in these assets to generate revenue while ensuring that original capital does not erode. However, every asset’s performance depends on market conditions and other factors.
Generally, investors build a portfolio based on their financial objectives, risk tolerance levels and investment horizon. Experts advise that a diversified portfolio helps to reduce risk and generate better returns from investors. Thus, balancing the risk-return trade-off.
Depending on the investor’s knowledge and expertise about the financial market, they may either choose to manage the portfolio themselves or seek assistance from financial advisors.
What are the Components of a Portfolio?
The different financial instruments included are called asset classes. Investors need to ensure that there is a good mix of assets. This helps to build a balanced portfolio which helps to foster capital growth with limited or controlled risk. The following are the components of a portfolio –
Equity or stock is the most common component. It represents ownership in the company on the proportion of shares held by the shareholder. This asset class has gained popularity over the last decade. Furthermore, equity can be classified as large-cap, mid-cap and small-cap based on the company’s market capitalization. Equities become a source of income when the company makes profits, it distributes a portion of profits through dividends. Also, the shares bought are sold at a higher price depending on market conditions to make profits. However, this component has a significant risk factor.
2. Fixed Income
This is again the common and oldest component. It includes corporate bonds, government bonds, government schemes, etc. Such instruments are issued for a fixed maturity period, paying fixed interest payments to investors until maturity. Moreover, fixed-income instruments are relatively more stable than equity but offer lower rewards.
3. Cash and Cash Equivalents
This component is also known as a money market instrument, as investors prefer this for a short-term duration. It includes treasury bills, commercial papers, certificate of deposits, etc. The primary advantage of this component is that they are highly liquid assets which can be redeemed easily within 90 days. Also, this is a safe investment component in an investor’s portfolio due to high liquidity.
4. Real Estate
This component comes in many forms (tangible and intangible) where investors make money on price appreciation. Tangible focuses on plots, apartments, villas, commercial buildings, etc. On the other hand, investors can buy in a dematerialized form through Real Estate Investment Trusts(REITs), which can be tedious work.
Gold is a prevalent investment component for Indian investors. Many investors use gold to hedge portfolios or for value in their portfolios. Also, this component performs well when the economy is weak, and other components perform poorly.
Alternative investments can also be included in the portfolio. It can be any asset whose value can grow and multiply. For instance, oil, derivatives,
Types of Portfolio
There are different types of portfolios, but here we list a few common ones. No portfolio is an ideal portfolio for an investor. To create a portfolio, you can use a blend of different styles based on your requirements. The following are the types of portfolios –
As the name suggests, the portfolio is aggressive because it aims for higher returns and takes higher risks to achieve its objectives. Generally, the primary portfolio composition is stocks with high beta value. However, these stocks are highly volatile. Also, this portfolio comprises other risky components. Investors with high-risk tolerance levels, such as someone young with a long-term horizon, prefer such a portfolio. Therefore, it is essential to manage risks prudently. Because the success of a portfolio largely depends on keeping minimum losses and better profits.
A defensive portfolio is the opposite of an aggressive portfolio, sometimes called a conservative one. This type is for low-risk tolerance investors, like someone with a short-term goal or closer to retirement. Also, such portfolios contain more fixed-income instruments or traditional investment schemes less risky than stocks. Also, it comprises stocks with low beta value and select sectors that do well in volatile markets. Therefore, this composition can be a safe bet for many investors.
The income portfolio focuses on components that produce regular income, such as bonds or dividend-paying stocks. These instruments usually pay investors at regular intervals like quarterly, half-yearly or yearly. Also, some options in mutual funds and government schemes pay monthly dividends. However, it is vital to understand that the performance of these instruments in an income portfolio is subject to market conditions. Typically, this portfolio is a good fit for retirees who rely on income from their investments when they stop working.
A speculative portfolio has the highest risk among all types of portfolios. Here, the portfolio is not just aggressive, but it also bets on instruments that could perform well in future. For instance, investors bet on Initial Public Offerings (IPO) or stocks that could be turnover in future. Similarly, investors buy bonds or debentures whose credit ratings are low with an assumption of high returns. Also, some investors bet on options or futures contracts to hedge the portfolio, but it can be otherwise. Therefore, investors must do due diligence while building this portfolio, as the risk is high. Moreover, experts advise capping these bets to prevent the portfolio from significant losses.
A hybrid portfolio is an amalgamation of different assets with varying fundamentals to earn the best of growth and dividend yield investments. This portfolio offers great flexibility. Also, it creates a balance of equity returns along with high-grade bonds and other instruments. Therefore, it offers diversification across several asset classes with overall stability.
Things to Consider Before Building a Portfolio
The process of building an investor’s portfolio depends on multiple factors, which are very personal. The following are the factors to consider while building a portfolio –
1. Time Horizon
Time horizon is the number of years or months the investor will invest to achieve their objective. It means that investors must modify their portfolios based on their objectives. Also, different time horizons entail different risk tolerance levels.
Typically investors with short-term goals or nearing retirement may prefer a conservative portfolio with a significant portion towards less risky components like cash or cash equivalents, bonds and others towards high-yielding instruments.
On the other hand, investors with long-term goals or younger ones may prefer investing a significant portion towards highly risky instruments. Thus, this gives investments time to accommodate the changing market dynamics, which may favour the investor.
2. Risk Tolerance
Risk tolerance refers to an investor’s ability to lose a given amount of their capital in anticipation of higher future returns. For instance, investors with high-risk tolerance levels are likely to risk most of their investments, in high beta stocks, real estate, oil, etc., with an expectation of higher returns. On the contrary, investors with low-risk tolerance levels are more inclined towards secured assets like large-cap stocks, investment-grade bonds, cash equivalents etc., which can preserve their original investment.
3. Investment Objective
Investment objective refers to the investor’s aspiration to achieve a given level of return or saving for a particular goal or desire. Some investment objectives can be children’s education, retirement, children’s marriage, buying a home, etc. Therefore, this is an essential factor influencing the portfolio allocation based on investors’ risk-taking capacity.
A key to a successful portfolio is diversifying across all asset classes. This is an effective way to minimize losses. Simply put, if one asset class performs poorly, it won’t impact the entire combination of asset classes. Also, investors can diversify between and within asset classes. For instance, investors can diversify across asset categories across stocks, bonds, real estate, commodities, etc. Similarly, diversification within a single asset class means investors can buy funds across large, mid and small-cap funds to achieve a healthy mix.
Therefore, you must understand that one portfolio does not fit all. Everyone has a different financial position and requires a unique approach. Also, you must monitor your strategies regularly to ensure your asset allocation is aligned with your financial goals and rebalance frequently. In case you are unsure about how to build the right portfolio, you can always consider seeking our services at Scripbox.