There is no guide to the perfect investment portfolio. Each of us has different preferences, financial options, expected returns and a different level of willingness to take risks. An investment portfolio is therefore a purely individual matter. We create it in a way that corresponds as much as possible to our current options and circumstances.
Books on investing
There are many books on investing that can help us build our investment portfolio. One of them is a book published by professors Andrew Lo of the Massachusetts Institute of Technology (MIT) and Stephen Foerster of the Ivey Business School Western University, titled “In Pursuit of the Perfect Portfolio”. Ten personalities from the financial world, including Harry Markowitz, Bill Sharpe and Myron Scholes, discuss the creation of the perfect investment portfolio with the authors of the book. The main thing the book tells us is this, there is no consensus and no universal perfect portfolio.
Conservative, dynamic and balanced investments
The conservative component consists of investments with a minimal risk of decline in value. These are especially popular among people who are afraid of taking too many risks. With conservative investments, the risk is almost negligible, but so is the return. They include term deposits, savings accounts, money market funds, and bond funds that invest in investment-grade bonds (especially government bonds). We can also include some real estate funds among them. However, they must have a low debt load. We can also include some shares (stocks) here. Especially shares of large global companies, or state-co-owned enterprises that operate in prosperous sectors.
We can build our entire investment portfolio from conservative investments. However, the investment period should not exceed five years. In the case of longer-term investments, it is better to opt for something more dynamic, as the level of risk decreases with the duration of the investment.
The dynamic component consists of risky investments. This primarily includes shares. Furthermore, corporate bonds (especially of less well-known companies), commodities (gold, silver, platinum, etc.), which have even greater fluctuations in value than shares. Alternatively, investments in foreign currencies.
To make a dynamic investment as profitable as possible, we plan it for the longest possible period of time (at least 20 years). We consider a dynamic portfolio to be one where conservative investments make up only 0 to 20% of the total volume.
A balanced investment strategy is suitable for those who want to invest for a period longer than 5 years. Balanced investments include both a conservative and a dynamic component, with the dynamic one making up 40 to 60% of the total investment volume. The rest consists of the conservative component. The profitability of this investment strategy can be around 6%.
To spread the risk over 25 years, our investment strategy can look as follows:
- dynamic investments for the first 15 years,
- balanced investments for the following 5 years,
- conservative investments (with minimum risk) for the last 5 years (when we will have the most money).
Investment portfolio
Before we start creating our ideal investment portfolio, we must clarify our investment goals:
- What return do I expect?
- What decline in value can I withstand?
- What is the time horizon of the investment?
An important factor is also whether we have any experience with investing. If not, we have a choice of two options. We can either focus on a conservative strategy, where the risk of loss of value is minimal, or we can use the services of an investment adviser. They will outline the investment options according to our financial possibilities and requirements.
What return do I expect?
The return depends mainly on the riskiness of the investment:
- 2 to 3% per year,
- 4 to 5% per year,
- 6 to 8% per year.
As retail investors, we had better forget about higher percentages. That could already be a big gamble for us.
What decline in value can I withstand?
This depends mainly on our financial situation. Before we start investing, we must get a clear overview of our financial possibilities. Based on this, we will find out what decline in value we can withstand:
- none,
- a maximum of 10%,
- 20 %,
- 30 %,
- 40 %,
- 50 %.
It is also important to know how much money we are willing and able to invest regularly.
Time horizon of the investment?
We determine when we will need the invested money and what we want to use it for. Based on this, we set the time horizon of the investment:
- Less than 3 years,
- 3 to 5 years,
- 5 to 10 years,
- 10 years and more.
Our age plays an important role here. If we choose a more dynamic strategy, we must take into account the possible risk of losing the money. The younger we are, the more likely it is that we will shake off this loss and regain the money through a better strategy.
Setting these goals is crucial for our investment strategy and investment portfolio. We decide whether we will head towards conservative, dynamic or balanced investing. If we know that we will only be able to withstand a minimal decline, or if our time horizon is less than three years, we had better leave our money in a savings account. If we are willing to invest for a period longer than three years and can stomach a short-term decline in the value of our investment, then it makes sense.
Greater risk = greater return
Return and risk go hand in hand. In general, the greater the risk we take, the greater the return we achieve. It is dynamic investments that generate the highest returns in the long term. If I want to achieve larger sums of money, I direct my funds into dynamic investments (shares). Although we must expect a short-term decline in the value of shares, in the long term it is the most profitable strategy.
It can happen that once in a while (usually every five to ten years), there is a significant but temporary decline in shares. We must count on this. However, this is usually a temporary situation and shares regain their value and start growing again. We can, however, take advantage of this situation and buy more shares at the moment of the drop in value. It should be noted that long-term equity funds are the most profitable of all types of funds. We can count on a net return of around 8% per year.
We must keep in mind that our investment portfolio is the best for us at this moment. However, this may not be the case forever. For example, Professor Andrew Lo states in his book that “we are all constantly changing, we are a product not only of our time, but also of our history and experience”.
