5 steps to constructing your portfolio

5 steps

Constructing an investment portfolio is about choosing a range of investments that are targeted at achieving your goals & objectives at a level of investment risk that you’re comfortable with. The key elements are asset allocation followed by the specific investment selection.

You will first need to choose the type of account you wish to open, as that will have a bearing on how you construct your investment portfolio.

Firstly, it’s important to determine how much risk you are willing to take on. How much of your investment portfolio would you be comfortable potentially losing in the short-term in order to meet your long-term goals?

There are many factors that affect your attitude to risk, including:

  1. Your investment time horizon. Over how long are you looking to invest for?
  2. Your personality. Are you the type of person that would lose sleep if your portfolio were to fall in value by a few percent, or would you thrive on the thought that your portfolio could grow in value greatly, even though it could potentially see large falls in the short-term?
  3. Your overall asset base. What is the amount of money you are investing relative to the value of all of your assets?
  4. Your job and/or income stability. Are you confident in your future earnings?

The last two points affect your ‘capacity for loss’, which is defined by the Financial Conduct Authority as:

“… (your) ability to absorb falls in the value of (your) investment. If any loss of capital would have a materially detrimental effect on (your) standard of living, this should be taken into account in assessing the risk (you) are able to take”. source: FCA (formerly the FSA) – Assessing Suitability, January 2011.

Once you have thought about the above, you could place yourself into one of the following investment risk categories:

  • Cautious: people in this category are prepared to take a very small amount of risk but capital protection is of paramount importance. Their portfolio will focus on investments which provide low returns over the long term but present a limited risk to their capital.
  • Cautious-Moderate: people in this category are prepared to take on a small amount of risk in order to increase the chances of achieving a real return, but they only want to risk a small part of their capital to achieve this.
  • Moderate: people in this category are prepared to take a moderate amount of investment risk in order to increase the chance of achieving a reasonable long-term return, but they wouldn’t want to see their capital fall in value significantly.
  • Moderate-Adventurous: people in this category are prepared to take an above average degree of risk with their investments in return for the prospect of improved long-term returns. They are prepared to see the value of their investments go up and down a relatively large amount in order to achieve this.
  • Adventurous: people in this category are prepared to take a substantial degree of risk with their investments in return for the potential of the highest possible long-term performance. They understand and are comfortable that over some periods of time there may be significant falls, as well as rises, in the value of their portfolio.

Time to set goals

Once you have decided on your attitude to risk, you need to determine exactly what your objectives and goals are. What are you trying to achieve by making these investments?

  • Are you looking to protect your hard earned money from erosion due to inflation?
  • Are you looking to provide yourself with income now?
  • Are you looking to grow your capital for a specific purpose in the future?
  • Are you looking for a combination of the above?

Investment objectives can be placed within three broad categories:

  1. Income
  2. Capital Growth
  3. Balanced (a combination of income and capital growth)

Whatever your objectives, it is very important that it’s defined from the outset and reviewed against how your investment portfolio is performing so it can be adjusted if necessary.

For more information about how to decide on your objectives please visit our top 10 tips for investors.

Asset allocation

Once you’ve decided on your investment objectives and goals, you need to decide on what mixture of asset classes will help you achieve them at a risk level you’re comfortable with. The asset allocation decision is an important one because history has shown that it is this, as opposed to the specific investment selection, that produces the majority of returns. Furthermore, allocating your money across a range of assets provides you with diversification benefits which includes the reduction of risk.

What is asset allocation?

Asset allocation is the process of allocating your money to key asset classes. These include:

 GrowthIncome (yield)
Fixed Interest (e.g. bonds)Increase in bond valueCoupon
PropertyIncrease in property valueRent
Equities (shares)Increase in share priceDividends

The table above shows where returns from each asset class are derived from.

In normal circumstances, the proportion of an investor’s portfolio which is allocated to cash and fixed interest securities would decrease as you move up the risk scale, whilst the proportion allocated to equities would increase. An investor’s objective may influence their portfolio asset allocation due to the prevailing characteristics of different asset classes at the time of portfolio construction. For example, if an investor with an income objective were constructing a portfolio at a time when yields (income paid) on fixed interest securities were relatively low, whilst yields on equities were relatively high, they may choose to have less exposure to fixed interest and more exposure to equities. The asset allocation of an investment portfolio need not be set in stone; it can be altered over time to meet changing objectives, risk tolerances, and market conditions.

Below are the investor risk categories described earlier with guidance on the asset allocation that could apply to a portfolio at each level:

  • Cautious: typically, only a small amount of riskier assets would be included in a portfolio. A typical asset allocation would be mostly invested in fixed interest and cash, with a small element – up to about one-third – in equities and property, which can boost longer term returns but are associated with more risk.
  • Cautious-Moderate: a typical portfolio will have slightly more than half invested in fixed interest investments and cash. The other, smaller half of the portfolio will be invested in equities and property.
  • Moderate: typically,a moderate portfolio will have a slightly higher proportion of equities and property compared to fixed interest and cash
  • Moderate-Adventurous: a typical portfolio will be invested mainly in equities but with up to around one-third invested into other assets to provide a reasonable level of diversification.
  • Adventurous: a typical Adventurous investor will have a significant proportion of their investments in equities, with a small exposure to other asset classes.

The above is purely for guidance purposes only and should not be construed as investment advice. Your asset allocation will be affected by a range of factors specific to your personal circumstances and the descriptions above take no account of these.

Once you have established your asset allocation, you need to choose the specific investments within each asset class.

For the purposes of this section, we are going to assume that funds will be used to establish your portfolio. Funds have the advantage of giving you quick and easy access to a wide range of investment markets throughout the world and provide instant diversification. You will find that funds tend to fit into sub-classes within the main asset classes which can be a little bewildering at first. You can however look at individual fund’s ‘factsheets’ (available within the platform and other sources) to find out what a fund is trying to achieve and understand where it could fit into your portfolio.

The number of funds within a portfolio and the weightings allocated to each should be aimed at providing sufficient diversification within your chosen asset allocation.

An example which brings together the sub-factors of fund selection is one in which an investor adopting a moderate level of risk with an income and growth objective and decides to allocate 40% of her portfolio to UK equities. Within this 40% allocation, she decides to invest in 5 funds, of which 3 are UK equity income funds (with an average yield of 3.5%) and 2 are UK growth-orientated funds (with an average yield of 1.5%). She decides to weight 2 holdings each at 9% of the portfolio value, one holding at 8% of the portfolio value and 2 holdings at 7% of the portfolio value.

For more information, please see the types of fund page and picking a fund page.

Time to invest

Once you’ve decide on your asset allocation and the specific investments you are going to use, it’s time to start investing! Depending on whether you have a lump sum to invest initially, or whether you are building up with regular savings, how you go about investing into your chosen portfolio can vary.

You may decide that you have a lump sum now, and would like to invest it into your portfolio all at once. You may however prefer to invest it gradually over a period of time. Investing in this way has a number of benefits including volatility reduction. You can either do this by investing fully into individual investments and building the portfolio gradually, or investing a proportion of money into the whole portfolio in stages.

  1. Not establishing your risk tolerance: a portfolio should be appropriate for your attitude to risk. If you establish a 100% share portfolio looking to achieve 20% returns per year and then panic and sell out of the market if it falls in value by 20%, your investment portfolio is not appropriate for you. Investment into assets such as bonds, property and shares should always be considered as medium-to-long term investments.
  2. Over-diversification: diversification is a great risk reduction tool – it means you won’t have all your eggs in one basket – but having too many investments within your portfolio (over-diversification) can mean it becomes difficult to manage and the risk reduction benefits start to reduce.
  3. Asset allocation takes a back seat: history has shown that it is the asset allocation of a portfolio that produces the majority of returns, as opposed to picking specific investments, so make sure the asset allocation decision is your first point of call.
  4. Making rash investment decisions: simply reading or hearing about a great investment and then diving in without any thought leaves you lost as to how it is helping you achieve your objectives. Investment selection should bear in mind your objectives and asset allocation strategy.
  5. Having no objective: it’s amazing how many people simply invest without any real thought as to what they’re trying to achieve. Not having an objective is the easiest way to lose your way with investing.
  6. Not understanding the investment definitions and terms used in the investment world.