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Understanding Portfolio Construction: How to Diversify and Assess Risk

March 17, 2022
6
min

Constructing a portfolio that minimizes risk while maximizing potential gains is a delicate and ever-changing balance. Learn about the process of creating a portfolio.

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Diversification” is probably going to be the first word someone will hear when they start asking questions about how to limit the risk of losses on their investments. The simple fact is that being too heavily invested in any asset class, sector, or industry can leave investors vulnerable to market swings.

Portfolio construction is the process of choosing a mix of securities and instruments like bonds, stocks, and money market accounts that will minimize overall risk to achieve maximum returns.

What is portfolio construction?

Portfolio construction, and portfolio planning, is the process of putting together a blend of assets suited for a specific investor. It is a very personalized endeavor: What’s best for one investor may not be ideal for another.

This process generally begins with defining an individual’s financial profile and goals; assessing appetite and tolerance for risk; and considering when the investor will need to liquidate the investments. With this basic risk-return profile established, individual investors can then create an asset allocation strategy that aligns with their profile. An investor’s needs will shift as they age or have changing financial needs, which means reconsidering the strategy and periodically rebalancing the asset mix. Investors also decide whether they will actively manage their investments, choose an investment advisor who will do it for them or use a passive investing strategy.

What is modern portfolio theory?

Many contemporary financial advisors operate based on what’s known as modern portfolio theory, a way of selecting investments pioneered by American economist Harry Markowitz in the 1950s. Diversification is central to MPT, with the idea that investments are either high risk and low return, or the opposite—and that investors can optimize their portfolios by choosing a mix of both to minimize risk while achieving solid returns over time. The idea is that any investment in a portfolio must be viewed in context of the overall mix—and that the performance of any investment alone is not as important as how it affects the whole pie.

How to create an investment portfolio

This process of creating a portfolio often involves the following steps:

Create a risk profile

A risk profile will consider factors such as an investor’s age, investment goals, income, and personal preferences. The goal is determining a person’s tolerance for risk, or their ability to stomach potential losses in exchange for the opportunity for higher returns. Investors will generally fall into three categories of risk tolerance:

  • Aggressive. Willing to purchase volatile securities for the potential of high returns. This is generally considered an appropriate stance for younger investors with the long time horizons needed to ride out market volatility. 
  • Moderate. Those who seek a balance of stocks and income-generating bonds to mitigate risk. These investors usually have shorter time horizons—or financial obligations such as paying a child’s college tuition—than more aggressive investors. 
  • Conservative. Those who want to maintain the value of their portfolio with the lowest possibility for risk. These investors may be either close to retirement or in retirement, or their financial position doesn’t allow for much risk-taking. 

Determine appropriate asset allocation

Once an investor has determined their risk profile, they can move on to determining the appropriate mix of assets in their portfolio, also known as asset allocation. Investors commonly diversify a portfolio by asset class. Each of these asset classes performs differently depending on market and economic conditions. 

  • Stocks. Also known as equities, these are usually the most aggressive class with higher potential risk, but also the potential for higher long-term returns. To mitigate risk within this asset class, investors may hold multiple sectors and industries; diversify by size or market cap; and style (growth, value, and socially responsible).
  • Bonds. Also known as fixed income, these are loans an investor makes to the U.S. government, states and municipalities, and corporations. Bonds carry different credit risks, yields and maturities. As a rule of thumb, when bond prices go up, stock prices tend to fall, and vice versa.
  • Other investments. Investors may decide to hold money market funds and short-term certificates of deposit, which have little risk and can be quickly converted into cash; international stocks for different opportunities and risk levels than domestic stocks; real estate funds, which allow investors to invest in real estate without having to purchase property; commodity funds that invest in oil, gold, timber land or even frozen orange juice; and asset-allocation funds created and managed specifically as tools for diversification.

Owning a mix of assets that come with different risks and potential rewards is part of a diversification strategy.

Establish the portfolio

Once an investor has decided how they would like to allocate their assets, they can fund those choices. They might open a brokerage account to buy stocks and bonds or set up a crypto wallet to invest in cryptocurrencies.

Analyze and rebalance the portfolio

Investors’ needs and goals change over time, which is why most active investors and financial advisors review portfolios at least once a year. Market changes, too, may cause an initial asset allocation to shift in weight. Restoring the desired asset mix is known as rebalancing. 

Review strategically

When investors analyze their portfolio and decide to rebalance, they may have to take account of the tax implications. For instance, selling stocks that have appreciated could result in capital gains taxes. One strategy sometimes used is to sell other shares that have declined in value, incurring losses that can be applied against capital gains tax liabilities. Managing this process often requires the guidance of a financial or tax advisor.

Assessing risk tolerance

Every investor confronts the choice between risk and reward; the safest investments tend to offer returns that won’t help a portfolio gain value, while investments that seem to offer outsized returns have a greater chance of generating losses. These losses can be especially problematic for investors with shorter time horizons and who can’t wait for markets to recover, which they tend to do over time. 

Assessing an investor’s risk tolerance is highly personalized. One way to begin the process is to use one of the online questionnaires offered on many personal finance websites. The Securities and Exchange Commission notes that while such sites can be useful, investors should be aware that “the results may be biased towards financial products or services sold by companies or individuals sponsoring the websites.” 

The dynamic portfolio construction process

Dynamic portfolio construction, or dynamic asset allocation, is the strategy of frequently adjusting a portfolio’s asset mix as markets and the economy change. This process also takes into account an investor’s time horizon (or the time they have before they plan to withdraw money from their investments) and how their risk tolerance changes over time.

The bottom line

Constructing a portfolio that minimizes risk while maximizing potential gains is a delicate and ever-changing balance. Investors can reduce risk by building a portfolio made up of different asset classes in various regions, sectors, industries, companies, credit risks, and maturities. An investor’s risk tolerance and time horizon will influence these decisions as they keep their portfolio mix aligned with their investment objectives.

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