Citi Personal Wealth Management

6 Steps to Building
Your Portfolio

Building a portfolio is sort of like building a house. You want a design that you will be happy with and that meets your family’s needs. You’ll need to use a wide variety of materials. And what counts isn’t just the quality of those materials but also how they work together.

Here are six steps to consider to help build the appropriate portfolio for you.

Step 1: Establish Your Investment Profile

No two people are exactly alike. So, when creating a portfolio, consider establishing your investment profile that is unique to who you are. In a nutshell, that profile should include what are your goals and what is the time horizon for those goals. For example, settling on your goals such as retirement will give you a sense of your time horizon — how long you’ll be investing your money for each goal. So, then, for a goal, like retirement, you may have 20 to 30 years on your time horizon. But then another goal, like investing for a child’s college tuition, may be 10 to 15 years away.

Once you’ve established your time horizon for each goal, you’ll then need to establish your investment objectives for pursuing those goals. For example, do you want to create a portfolio that is conservative, moderate or aggressive? To answer that question, you will need to understand your risk tolerance, which includes factors such as your comfort level to fluctuations in the value of your portfolio. For example, even if your goals are decades away, you still have to live with your investment mix through the intervening days and weeks. That’s where a well-constructed portfolio can help. Let’s walk through some of the basics of creating a portfolio in the next five steps.

Step 2: Allocate Assets

Your asset allocation is your portfolio’s basic investment mix of individual stocks and bonds, mutual funds, exchange-traded funds (ETFs), with perhaps smaller stakes in other investments and cash.

Cash investments are things like money market mutual funds and savings accounts, while other investments can include commodities, precious metals, and real estate. Stocks have the potential for high returns but also carry higher risk. Bonds and cash investments are often added to help reduce a portfolio’s overall volatility and perhaps to generate income. Mutual funds and ETFs may offer the benefit of diversifying among several stocks and bonds. Meanwhile, other investments like commodities and precious metals, which are not suitable for all investors, can suffer wild price swings and great risk, but, because they often perform unlike other investments, they too may sometimes help reduce a portfolio’s overall volatility.

Make no mistake: Your asset allocation is possibly your most important investment decision. Indeed, it may likely have a greater impact on your portfolio’s risk and return than the individual investments you select.

You may have already begun saving and investing for your financial future. But is your asset allocation currently set up the right way for you? To answer this question, you need to consider different factors, including:

  • Your goals and how far off they lie. Keep in mind that, even at age 65, you may have a time horizon of 25 or 30 years, and possibly longer, if you’re investing with your children or grandchildren in mind.
  • Your overall financial profile. The sort of portfolio you construct should depend on your overall financial profile, which includes your sense of your job security, how steady your paycheck is, how much debt you have, how much you expect to receive from Social Security, and whether you have any other assets, such as rental properties or a stake in a small business.
  • Your risk tolerance. Everyone has a different stomach for risk. You may not know how much risk you can truly tolerate until you have invested for many years or you have lived through a brutal bear market. If you are fairly new to investing, it may be prudent to take less risk than you think you can tolerate.
  • Your comfort zone with risk and returns. If you are comfortably on track to accumulate enough for your investment goals, you might not need to invest all that aggressively. You could, of course, choose to take more risk in an effort to amass an even larger nest egg or to reach your goals even faster. But you may end up taking more risk than you need to — and that could come back to haunt you.

Step 3: Decide how to diversify

Now that you have settled on a basic mix of stocks, bonds and other asset classes, you’ll need to drill down a little further and consider how you want to diversify within these asset classes.

There are several ways to look at the diversification of your portfolio, such as the sectors to select and the industries within those sectors and the individual securities to select within an industry, including the size (market value). Let’s take a look at some of the basics here.

Stocks

Among U.S. stocks, you might choose to invest in a mix of large, medium-size and small companies. The ranges of stock sizes vary, but, in general, large caps are companies with total stock market values of approximately $10 billion or more, mid caps have market capitalizations of $2 billion to $10 billion, and small cap companies have market values under $2 billion.

Stocks also come in two basic styles: growth and value. Prices of growth stocks can seem high relative to their earnings, but they may also have better than average growth prospects. Meanwhile, some investors favor value stocks because they believe their prices don’t fully reflect fundamentals such as a company’s earnings or dividends.

There’s also been growing interest in international investing among U.S. investors. At one time, the argument for investing abroad was diversification: When U.S. stocks sag, other markets might hold up better. Thanks to globalization and the high correlation among many national stock markets, that argument is now harder to make. Instead, today’s case for international diversification often centers on currencies. (Correlation measures how much the movements of two or more investments are related.) Foreign stocks are priced in local currencies, so they can provide a potential hedge against a fall in the dollar’s foreign exchange value. The downside: Because foreign stocks can be buffeted by both turmoil in their local stock market and swings in foreign exchange rates, they can be more volatile than U.S. stocks — assuming you’re a U.S. investor.

Bonds

Bonds are typically considered more conservative than stocks because their prices tend to be less volatile. This does not mean they are risk-free, however. You may want to own a broad variety of bonds to reduce your exposure to a default by any one issuer. You might also include a variety of bond market sectors, each of which may fare well at different times. In fact, you could potentially diversify a portfolio by issuer (national governments versus individual states and municipalities versus corporations), maturity (short-term versus intermediate-term versus long-term bonds), credit quality (high-quality versus low-quality), tax treatment (taxable versus tax-free), the way interest is paid (fixed interest versus floating rate versus inflation-linked) and location (U.S. versus developed foreign markets versus emerging markets).

Cash investments

Cash investments, such as money market mutual funds, money market deposit accounts, short-term certificates of deposit and savings accounts, seek to avoid losing value. They might be part of your portfolio, though you probably shouldn’t hold too much because the yields are often modest, especially relative to inflation. You may want enough to take care of emergencies, to have handy when investment opportunities pop up, and to cover any major upcoming expenses.

Other investments

Other investments, such as commodities, precious metals and real estate, have the potential to add some more diversification to your portfolio because they sometimes outperform when stocks struggle — though there are, of course, no guarantees. But while a small stake in, say, commodities or precious metals may calm down a portfolio by rising and falling in a different pattern from other investments, they can — by themselves — be notably risky. This may create anxiety, especially if you are a nervous investor who focuses heavily on each investment’s fluctuations, rather than keeping an eye on your overall portfolio’s performance.

Step 4: Select investments

Once you have an asset allocation and diversification plan, picking individual investments may become easier, because you know which buckets you want to fill and what your target portfolio percentage is for each.

For instance, you might have earmarked 5% for emerging market stocks, so it now becomes a matter of finding the right investment for that slot in your portfolio.

For your stock bucket, you might use individual shares, mutual funds or ETFs. Selecting individual stocks can mean researching each company, including its sales, profits, market share, management and the competition within the company’s industry.

If you go the mutual fund or ETF route, you have another choice to make: whether to use actively managed or passively managed funds. With active funds, managers pick investments they hope will fare better than average. The goal is to outperform a market benchmark, such as the Standard & Poor’s 500 for large cap stocks or the Russell 2000 for small cap stocks. By contrast, passively managed funds, otherwise known as index funds, try to match the performance of a benchmark index. The most popular of these funds track the S&P 500, but you can also find funds that track mid- and small-cap benchmarks, international indexes, and even indexes that follow specific industries, such as health care or financial stocks.

You have similar choices with bonds. You can buy individual government, corporate or municipal bonds, or you can opt for mutual funds containing bonds, buying either an actively managed bond fund or one that mimics the performance of a benchmark index.

Step 5: Consider Taxes

As you buy investments to build your desired portfolio, you need to decide which of your accounts should purchase these investments.

This is sometimes called “asset location” — and the big issue here is taxes. You might consider holding investments that tend to be tax-inefficient, such as taxable bonds, real estate investment trusts and actively managed stock mutual funds, in tax-deferred accounts. That way you can defer the tax bill that these investments generate until you start drawing down these accounts.

By the same token, investments that are potentially more tax-efficient, including index stock mutual funds, exchange-traded index funds, tax managed stock funds and individual stocks you plan to buy and hold, might find a home in your taxable account.

Step 6: Monitor your portfolio

Life — and the financial markets — change frequently, and that means you should regularly review your portfolio.

For instance, your personal circumstances can change, which may alter your goals and that in turn may mean changing your investment mix for your portfolio, including taking a more conservative or aggressive approach based on an increasing or decrease in your risk tolerance. But even if all’s quiet in your everyday life, the markets are rarely quiet, so you may want to check on your portfolio at least once a year and possibly more often.

In fact, even if you haven’t done any buying and selling and even if your risk tolerance hasn’t changed, you won’t necessarily have the right investment mix today. Let’s say you had earmarked 60% of your money for U.S. and foreign stocks and 40% for high-quality bonds, certificates of deposit and other conservative investments. Thanks to turbulent markets, you may have less in stocks than you intended and more in conservative investments.

To help get your portfolio back on track, consider “rebalancing.” When you built your portfolio, you likely settled on target portfolio percentages, specifying how much should be invested in each market sector. But because of falling share prices, your portfolio may no longer be in line with your target investment mix of 60% stocks and 40% conservative investments — and you might need to add money to the stock side of your portfolio to build it back up to 60%. By adding to your stocks, you’ll likely be better positioned if stocks resume their rally.

But rebalancing isn’t principally about boosting performance. Rather, it’s about managing risk. By rebalancing, whether it is adding to stocks at a market bottom or lightening up on shares during a bull market, you can help your portfolio stay closer to the risk profile you originally settled on.