As a new investor, one piece of advice you hear time and time again is that you need to have a balanced investment portfolio. The general idea is to maintain an investment portfolio that has a proper balance between risk and reward in order to meet your long-term financial goals.
You’re told that if your investment portfolio isn’t balanced correctly, it will leave you exposed to significant losses. You’re told that a balanced portfolio is key to long-term investing success.
But what exactly is a balanced portfolio and how do you create and manage one?
What Is a Balanced Investment Portfolio?
A balanced investment portfolio is a highly diversified collection of financial products designed to produce long-term gains while protecting you from significant losses that can result from the failure of one or more investment decisions.
The creation of a properly balanced investment portfolio starts with generally accepted levels of diversification and is adjusted to the unique risk tolerance and financial goals of the investor behind the portfolio.
Because a balanced portfolio consists of a heavily diversified collection of assets, if one or two of these assets experience significant losses, gains in the other assets across the portfolio will soften the blow or even outpace the losses to yield an overall gain. This lets you feel a degree of confidence in your investment portfolio without worrying about whether each individual asset is up or down.
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Steps to Creating a Balanced Portfolio
Although at first glance creating and managing a balanced investment portfolio may seem like a convoluted process, it’s actually quite simple. In fact, by following the four simple steps below, you’ll be well on your way to stock market success.
Step 1: Always Consider Diversification
The most important aspect of a balanced investment portfolio is diversification. Diversification is the process of investing small amounts of money across a wide range of assets and asset classes. This ensures that you don’t fall victim to the volatility of an individual stock or other single asset within your portfolio.
Once you get the general idea of diversification down, the rest is all about adjusting your portfolio to your unique preferences.
The 5% Rule
A general rule of thumb in terms of creating a well-diversified portfolio is known as the 5% rule. This rule suggests that no more than 5% of your total investing capital should be invested into any single asset. Moreover, it suggests that no more than 5% of your investing funds should be invested across any group of high-risk investments.
For example, if you have $10,000 to invest, the 5% rule stipulates the following limits:
- General Investments. Based on a $10,000 investment portfolio balance, you should invest no more than $500 in any single stock, bond, mutual fund, exchange-traded fund (ETF), index fund, or any other investment vehicle in a balanced portfolio, regardless of how low the perceived risk associated with the investment is.
- High-Risk Investments. High-risk investments can be hard to ignore, as high risk usually comes with the potential for compelling gains. However, you should never expose more than 5% of your investing dollars to high-risk investments like penny stocks and over-the-counter (OTC) stocks. So, you should have no more than $500 invested across all of your high-risk positions based on a $10,000 portfolio balance. That leaves 95% of your investment funds, or $9,500, to be invested in low- and moderate-risk general investments like bonds, investment grade funds, and large-cap and blue-chip stocks.
Keep in mind that the 5% rule provides maximum investment guidelines, not minimums. You don’t have to invest 5% of your portfolio into high-risk assets, nor do you have to invest 5% of your portfolio in every stock, ETF, or mutual fund you buy. As long as you don’t invest any more than 5% in a single asset or across all high-risk assets, you’ll create a well diversified investment portfolio.
Consider Investment Grade Funds
To add to the level of diversification within your portfolio, consider investment grade funds. These include index funds, ETFs, and mutual funds. Because these funds are designed to expose investors to an entire stock market index or sector, or to the entire stock market as a whole, these investments are naturally heavily diversified.
If you decide to go the investment grade fund route, there are a few factors that should be considered before making your investment:
- Expense Ratio. The expense ratio of an investment grade fund reflects the amount of assets in the fund that are used to cover the cost of its annual expenses. The higher the expense ratio, the more costs associated with the fund will cut into your return on investment.
- Average Long-Term Investment Return. When choosing an ETF, index fund, or mutual fund, it’s worth looking into the returns the fund has experienced over the past year as well as annualized returns over the past three, five, and 10 years. This will give you a view of how the fund has done historically. Although past performance is not always indicative of future performance, it’s well worth looking into the past performance to see how well the fund managers have done over time.
- Income. Finally, some funds are geared toward growth, some toward value, and some toward income. Often, income-geared funds will underperform when it comes to price appreciation, but that underperformance is largely made up by the income the investment generates, such as through dividends. So, if you’re going to look into ETFs, mutual funds, and index funds that revolve around income, make sure that you look into the total returns generated through the fund rather than simply considering price appreciation.
Diversification Across Asset Classes
When investing, you have the option to invest across a wide range of different asset classes. You’re not simply tied to stocks, bonds, and funds. It’s also a good idea to think outside of the box and consider real estate investments, precious metals, foreign currency, and other nontraditional types of investments.
When diversifying heavily across different asset classes, you’re protecting yourself from significant losses should assets across an entire class lose significant value.
Believe it or not, it happens all the time. For example:
- Precious Metals. Precious metals are known to experience growth during tough economic times and declines when economic times are positive. This is due to their standing as a safe-haven investment.
- Bonds and Other Fixed-Income Investments. Bonds and other fixed-income investments like bond funds provide coupon rates, which are equivalent to interest rates on loans and credit cards. However, this makes the bond market heavily exposed to interest rate risk. As interest rates rise, the value of fixed-income investments fall, while reductions in overall interest rates are a positive for the bond market.
- Stocks and Investment Grade Funds. Stocks and investment grade funds are often at the mercy of economic development. When economic conditions falter, these investments tend to experience significant losses.
Taking diversification to the next level, it’s also a good idea to look into international stocks for opportunities. In particular, investments in emerging markets offer an exciting opportunity to tap into the growth of global markets seeing incredible expansion.
However, global diversification isn’t just about taking advantage of growth in emerging markets. It also protects your portfolio from significant losses, should the United States economy take a hit while the global economy is performing well.
In these cases, ensuring that you are exposed to growth in international markets will soften the blow of declines experienced here at home.
Step 2: Take Advantage of Time Horizon-Based Asset Allocation
You’ve likely heard that “time is money” since you were a child. You’ve learned that every second of the day is valuable, and wasting time is just like wasting money.
This statement is no more true anywhere else in the world than in the stock market.
It’s important to know your time horizon — that is, how long you have before you plan to need access to your investment capital. Adjusting your investment portfolio’s asset allocation to be in line with your time horizon is just as important as choosing the right assets to invest in.
The general idea is that younger investors have more time to recover, allowing them the ability to recoup any losses should something go wrong. As such, with a longer time horizon, younger investors generally can take more risks.
As a rule of thumb, to adjust your portfolio based on your time horizon, all you need to do is consider your age. Many recommend balancing your portfolio so that your low-risk assets represent a percentage equal to your age. So, if you are 35 years old, 35% of your investment portfolio should be invested in low-risk asset classes like bonds and bond funds, while 65% of your investment portfolio should be allocated to higher risk assets like shares of stock. Once you reach age 50, you’d want half of your portfolio to be allocated to low-risk assets with half allocated to higher-risk assets.
Following this strategy, as you age your portfolio moves to a low-risk allocation, with most of your assets in the market being held in bonds and other low-risk investment vehicles by the time you hope to retire and live off your nest egg. This approach helps you to avoid sequence of returns risk, wherein an ill-timed market downturn wreaks havoc on your portfolio when you are least able to recover.
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Step 3: Adjust for Your Personal Risk Tolerance
Everything described above is based on the general amount of risk that the average investor is willing to accept, but everyone is unique. What if your risk tolerance is higher or lower than average? How would you handle asset allocation and diversification in that scenario?
Asset Allocation for Lower Risk
If you’d rather take a low-risk approach to investing, adjust your portfolio based on the following rules:
- The 2.5% Rule. If losing 5% of your portfolio’s value on a bum investment scares you, you may want to consider heavier diversification. Instead of following the 5% rule, make yourself a 2.5% rule. In this case, only 2.5% of your total investment portfolio’s value would be invested across all high-risk assets, with the maximum amount invested in any single asset being 2.5% regardless of risk.
- Asset Allocation. Another tactic to reduce your risk is to invest more money in bonds. Instead of using your age as the percentage of your portfolio you will allocate to bonds, use your age plus 10. For example, in a low-risk portfolio, at 35 years old, you might target having 45% of your investment dollars in a low-risk asset allocation. This allocation may be too conservative for some investors who prefer to be more invested in higher-risk assets with higher returns, but this approach may appeal to the more risk-averse.
Asset Allocation for Higher Risk and Potentially Higher Reward
If you’re more into living on the edge and are willing to accept a higher level of risk for the potential of a higher payout, you’ll want to follow these rules:
- The 7.5% Rule. Even in a high-risk investment portfolio, you shouldn’t have any more than 7.5% of your investing dollars tied up in a single investment regardless of risk, or across a group of high-risk investments. But you can adjust the 5% rule to a 7.5% rule if you want to walk on the wild side.
- Asset Allocation. In a high-risk investment portfolio, you’ll want to invest even more in stocks and other investments with high potential returns than you would in a medium-risk allocation, and less in conservative investments such as bonds. For a higher-returning asset mix, you might subtract 10 from your age to calculate your low-risk asset allocation. For example, if you’re 35-years-old, you would only allocate 25% of your investment dollars toward bonds, bond funds, and other low-risk assets. This allocation still becomes lower-risk as you age but leaves you invested in high-risk, high-returning assets longer, for a theoretically higher return in the long run.
Step 4: Rebalance Your Investment Portfolio Regularly
Creating a balanced investing portfolio is only the first step of responsible investing. At the end of the day, investing is not a set-it-and-forget-it endeavor. Even buy-and-hold investors are consistently rebalancing their investment accounts to ensure that their portfolios stay in line with their financial goals.
In the stock market, short-term downturns are a common occurrence, but it’s important to keep a close eye on your investments to make sure that any downtrends are indeed short term.
Moreover, as assets in your portfolio grow in value, you’ll notice that the rate of growth will be different across your individual investments. Assets that grow the most will come to represent a larger percentage of your portfolio, while slower-growing assets will lag behind and become a shrinking piece of the pie. This varying rate of growth will result in an unbalanced investment portfolio if not kept in check.
As a result, successful investors tend to go through the process of rebalancing their investment portfolios at least on a quarterly basis. Some of the most successful investors rebalance monthly.
There are three steps to rebalancing an investment portfolio:
1. Review Asset Allocation Following Recent Price Movements
With asset values growing and falling at different rates across your portfolio, your preferred allocation on individual investments will fall out of balance. So start by making sure of two things:
- Asset Allocation. First make sure that your asset allocation is still in line with your investment strategy. If stocks have risen to become too much of your allocation, cash in on some of your stocks and buy bonds to bring the balance back. If stocks are down or bonds have risen faster than stocks, you’ll want to cash in on bonds and add exposure to stocks to take advantage of the next market upswing.
- Maximum Investment Caps. Some stocks may grow to become worth more than your limit of 5% of your general-risk investment portfolio (or 2.5% in a low-risk portfolio or 7.5% in a high-risk portfolio). Should this take place, sell enough shares of that asset to keep it in line with your investment strategy.
2. Gauge the Performance of Individual Investments
Once your portfolio is back in line with your investing strategy, take a look at each of your individual investments. In particular, pay close attention to the performance of the investments since your most recent rebalancing of your investment portfolio.
As you do so, you’ll find that some investments are outperforming others, and in some cases investments are duds, with either flat movement or long-term losses.
In this step, you might want to cut your losses, selling your positions in the duds and freeing up those funds for investments that will provide you with better returns.
3. Look for New Opportunities to Fill in the Blanks
At the ends of your rebalancing process, you might find that you have uninvested cash in your portfolio. Due to inflation, unused cash is an asset that only loses value. So, instead of leaving cash lying around, look for new opportunities in the market to invest in.
A balanced investment portfolio is the key to compelling long-term investment returns while keeping risk at a minimum. Although some question the validity of diversification, the vast majority of experts suggest that investors maintain a healthy amount of diversification in their portfolios.
By following the steps above, you’ll have the ability to not only create a balanced portfolio, but you’ll have the tools you need to maintain and rebalance your portfolio regularly.
Monthly rebalancing may be cumbersome, but is well worth the time. Not only does this keep your investment portfolio more in line with your financial goals, it keeps you in the know with your investments, giving you the ability to act if significant losses are likely on the horizon.