Basics of Portfolio Construction Process

Building a portfolio is like building a house. You need a blueprint, the right materials, and regular maintenance.

The 5-Step Process

Step 1: Define Investment Objectives

Ask three questions:

1. Time Horizon: Are you investing for 1 year or 30 years?
2. Risk Tolerance: Can you handle seeing your portfolio drop 20% in a month?
3. Return Expectations: Do you need 8% or 15% annual returns?

Example: A 25-year-old saving for retirement has high risk tolerance (long horizon). A 60-year-old needs stability (short horizon).

Step 2: Asset Allocation

Decide the split between:

• Equities (Stocks): High risk, high return.
• Fixed Income (Bonds): Low risk, stable income.
• Cash/Equivalents: Zero risk, zero real return.
• Alternatives (Gold, Real Estate): Hedge against inflation.

Common Rule: 100 - Your Age = % in Stocks. (A 30-year-old: 70% stocks, 30% bonds)

Step 3: Security Selection

Within each asset class, pick specific securities.

• Stocks: Which companies? Growth or Value?
• Bonds: Government or Corporate? Short-term or long-term?

Step 4: Implementation

Execute the trades. Consider:

• Transaction Costs: Brokerage fees.
• Tax Implications: Capital gains tax.

Step 5: Monitoring & Rebalancing

Over time, your 70-30 split drifts to 80-20 because stocks grew faster. Rebalancing means selling some stocks and buying bonds to restore the original 70-30.

Loading quiz…