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  • Writer's pictureDamon C Collins, MBA, AAMS®, CFEI®

Building a Balanced Investment Portfolio

Updated: Mar 9, 2023


The first step in creating a balanced portfolio is to realize that the "balance" doesn't refer to the investments contained in the portfolio – it relates to the investor's goals, preferences, and risk tolerances. Investing is about increasing the return on your money over time to potentially higher levels than can be obtained from a savings account, but the trade-off is increased risk.


How can you build a balanced portfolio to help you reach your long-term goals? We provide

a step-by-step guide.


We cover time horizon, portfolio goal, and risk tolerance; many asset allocations can be constructed. But to keep it basic, we will cover conservative, moderate, and aggressive portfolio asset allocations.



Time Horizon and Portfolio Goals


Determining your appropriate balance starts with defining two variables: time horizon and risk tolerance.


It's common to use a formula of current age or x years to retirement to define your time horizon. Still, a more individually-tailored approach is to incorporate the goal of the portfolio. In other words, whether the portfolio is invested for growth or structured to preserve the capital that will replace a source of income. For instance, while a young investor with a long time to retirement may choose an aggressive allocation, a young investor planning a career break may want to take a different route.



Risk Tolerance


Whether you select a portfolio construction based on years to retirement or seek a portfolio that can meet other needs, your portfolio construction should also reflect the second principle – how you feel about potential loss. If the potential for gain is more important to you than the risk of loss, your aggressiveness for risk is most likely high. If the most important thing to you is to keep what you have, your risk tolerance is likely low. While your time horizon is essential, your risk tolerance should dictate the underlying selection of the asset classes.



The "Asset" Part of the Allocation


Portfolio construction is the next step once you have determined your time horizon and risk tolerance. An asset allocation combines groups of asset classes (stocks, bonds, cash, etc.) to create a portfolio that can help meet your needs and fit your risk profile. The assets have unique risk/return characteristics, creating an overall portfolio risk profile.


The chart below breaks down the return potential and risk of several asset classes and compares them.


Asset Classes Along the Risk/Return Spectrum


The chart makes clear that even within broad groups of asset classes, such as equities or bonds, there can be sub-asset classes that have different risk/return profiles. For example, emerging market stocks are riskier than developed market stocks and have a somewhat higher return potential.



Sample Portfolio Constructions


In the sample portfolios below, several combinations of asset classes with different portfolio weighting percentages create portfolios with varying profiles of risk, time horizons, and capital preservation or capital growth targets. The asset classes are at the broadest level in the examples. Of course, you can tailor your asset selection much more finely in your individual portfolio.



Conservative Allocation – Preserve Capital and Generate Income


A conservative allocation may be the right structure if you want a portfolio that provides a high level of income, whether because you are entering retirement or taking a financial risk in a different area of your life. For instance, if you are starting your own business, you may need your portfolio to preserve capital so that it can provide an income stream.


This portfolio is structured to preserve capital by investing in instruments that provide predictable income. If you are in retirement, the shorter time horizon is a consideration as there is less time to recover from a significant market drop.


A significant percentage may be held as cash in a higher yield savings or money market account, so it is readily available. The trade-off for higher and stable income sources is that the portfolio's capital base will not grow as much as more aggressive constructions.



Moderate Allocation – Flexibility to Meet Different Investor Goals


The moderate allocation may sound like a compromise – but it's not. It expands the options for different investor goals. It allows for capital growth in the portfolio, mainly through increased equity allocation. It also provides a measure of capital preservation through bond allocation and cash holdings.


While the percentage of bond holdings is lower and therefore income may be lower, investing part of the equity allocation in dividend stocks can help make up the difference while still providing some growth potential.


This allocation may work well for a broad range of investors at all points in their investing life. For instance, it may be a solution if you are far from retirement but are temporarily forgoing employment – perhaps to raise children or further your education – but intend to return to the workforce. You can structure it to help with income, but the risk allocation will also help keep your retirement on track.


Suppose you are a younger investor but are somewhat risk-averse. In that case, this allocation may provide some reassurance as you assess your portfolio performance and become used to market ups and downs.



Aggressive Allocation


The aggressive profile is weighted to prioritize growth over income. It reflects an investor with an appetite to take risks in hopes of accumulating higher returns. The caveat is that the time horizon will come into play as an extreme market drop will take time to recover. For this reason, a portfolio designated as aggressive should usually have a time horizon of 10 years or longer. This allocation is commonly recommended for younger investors who will have multiple decades in the market. It is expected that they will shift out of this as they enter different stages of their investing lives.



What's Right For You?


How you construct your portfolio is very important to meet your goals. Your financial advisor can help you select investments that reflect your unique approach to risk and return. Working together, you can craft an investment strategy for every phase of your life, ensuring that your strategy keeps pace with your changing goals and keeps you financially balanced.


 

This work is powered by Seven Group under the Terms of Service and may be a derivative of the original. More information can be found here.


The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but is intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax, or financial advice. Please consult a legal, tax, or financial professional for information specific to your individual situation.


Reviewed by FINRA.




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