How to Build an Investment Portfolio for Total Beginners

Summary: Building an investment portfolio involves determining your risk tolerance and investing in assets accordingly. If you’re risk-averse you want to invest more in cash equivalents and bonds. If you have a high risk tolerance, you can put more of your investments in stocks. The rest of this post will tell you the specifics.

Investing intimidates a lot of people. In fact, about 65% of young adults (aged 18-39) thought investing was scary or intimidating.

It can be hard to figure out which investments are right for you. Especially when there are so many choices to choose from. In fact, having too many choices has been shown to decrease your confidence in your investment decisions and make you less likely to make any decision at all. 

Don’t be afraid! While investing sounds scary, the worst thing you can do for your long term financial health is to not invest at all. This post will show you everything you need to know to start building your first portfolio. 

The 3 Categories of Investment Assets

Investment assets (things you invest in) are generally bucketed into three major categories: stocks, bonds and cash equivalents. 

One of the highest level decisions you need to make is how much of your portfolio you should invest in each of those. We’ll get to that a little later.

First, here’s an overview of each investment asset category:

Stocks

We already wrote an in-depth introduction to stocks, but here’s a short explanation. 

Stocks are shares of ownership of a company. When you purchase a company’s stock, you effectively become a part-owner of the company. If the company does well, your investment in the company does well. If the company doesn’t do well, your investment will also suffer.

Stock Categories

• Size: A company can be small (small-cap), medium (mid-cap), or large (large-cap). Generally, larger companies have lower risk but also have less reward while smaller companies have high risk, high reward.
• Industry/sector: This is the industry the company operates in, such as aerospace, information technology, biotech, consumer services, energy, etc. The stock price of a company can follow the general stock movement of its industry.
• Location: The biggest classification here is US and foreign stocks. You could also classify location even further by region, such as Asia, Europe, or South America. Historically, US stocks have had larger annual growth than foreign stocks, but foreign stocks may experience a larger growth in the future as countries develop.
• Style: Stocks can also be categorized by growth or value. Growth stocks refer to companies that have strong earning potentials, regardless of the current stock price. Value stocks, on the other hand, refer to companies whose stock prices are currently undervalued and have potential for upward price movement. Value stock investors are counting on the price to bounce back up like a rubber band.

Having an awareness of different stock types can help you decide how to diversify your stock portfolio. It might not be a good idea to have all your money invested in small-cap, water filtration stocks in Asia for example. Instead, you might want to have a spread between stocks of different sizes, industries, and locations. 

Stocks generally give you a high return on your investment, but at the cost of short term volatility/variation. This means that within a year, the stock market could go down by 20%, or it could go up by 20%. Overall, the stock market gives you an average return of 10% per year. 

Bonds

Bonds are issued by companies or government entities. When you purchase a bond, you’re lending money to the issuer, and you get a fixed rate of return. It’s like an IOU or a mini-loan. 

The interest rate established by the issuer when the bond is issued is called a coupon rate, which can be fixed or variable. The face value of a bond is the amount of money the bondholder will be paid when the bond reaches maturity. 

For example, a $10,000 bond with a 10-year maturity date and a coupon rate of 5% would pay $500 a year for a decade, after which the original $10,000 face value of the bond is paid back to the investor.

You can sell your bond before maturity, but the price varies. If the interest rate (in the U.S. or world market) goes up, your bond value decreases (since no one wants to buy old, lower coupon rate bonds), and vice versa. 

This is called the interest rate risk of bonds. There’s also default risk, which is the possibility that the issuer is not able to pay you the interests and/or principal on time. 

Bonds have lower-risk and lower-return compared to stocks. Data shows that long-term government bonds historically earn around 5% in average annual returns, versus the 10% historical average annual return of stocks.

Long story short, bonds are not 100% risk free, but the risk is much lower compared to stocks. 

Cash Equivalents

Cash equivalent investments protect your original investment and let you have access to your money. Examples include savings accounts, money market accounts, certificates of deposit (CDs), etc. 

They’re less about growing your money and more about keeping it safe, so they are low-risk and low-return. They’re not designed for long-term investment goals.

Besides these three categories, there are some alternative investments like commodities, cyber currencies, annuities, etc. We won’t focus on those because those aren’t as common and may be less beginner friendly.

In this article, we focus on stocks and bonds and their derivatives. They are the most common long-term investment options. We will explain what they are and their features, and tell you how to choose these options. 

Stock and Bond Investment Vehicles

While you can buy stocks and bonds individually, we will recommend you invest through investment vehicles like mutual funds, index funds, or ETFs. These are basically bundles of stocks and bonds that help you easily diversify/manage your portfolio based on your goals. 

We recommend you look for ones with low cost, meaning low management fees. Anything you pay in management fees is money that you could have put to work for yourself in the market. These fees can have a big impact on your profits over time. 

If you do the math, investing in a fund charging a 0.75% fee will lead to a reduction of 20% in net earnings over 30 years compared to investing in something with no fees (1.0975^30/1.1^30 if you’re a math person). Even though the fee sounds small at less than 1%, in the long run, it will have a big impact on your earnings.

Mutual funds

Mutual funds pool money from many investors, then employ a professional manager to invest that money in stocks, bonds or other assets. Each shareholder, therefore, participates proportionally in the gains or losses of the fund. 

Mutual funds allow investors to purchase a large number of investments in a cost-effective way. Such diversification is a big advantage of mutual funds because it enhances returns and reduces risks. 

Another big advantage is that they give individual investors access to professionally managed portfolios. This means investors don’t need to pick and manage the stocks themselves. 

Of course, the professional management comes at a price. Mutual funds charge annual fees (called expense ratios). These fees reduce the fund’s overall payout and your potential earnings. 

Index funds

An index fund is a type of mutual fund that passively tracks a financial market index, rather than paying a manager to pick and choose investments. For example, an S&P 500 index fund aims to mirror the performance of the S&P 500 by holding stock of the companies within that index.

Unlike actively managed funds that try to beat the market, index funds just try to match the market. This actually turns out to give better returns – passive funds have been successful in outperforming most actively managed mutual funds. 

For example, the data shows that during the five years ending December 2018, 82% of large-cap funds (basically actively managed funds that invest in large companies) generated a return less than the S&P 500. This means just meeting the market is already doing better than the majority of investors.

Index funds also have lower expenses and fees than actively managed funds, since they need less human management. 

Exchange-Traded Funds (ETFs)

ETFs are pretty much the same as index funds. The difference is that they trade on an exchange like a stock, which means you can buy and sell ETFs throughout the day. An ETF’s price will also fluctuate throughout the day while mutual funds are priced once at the end of each trading day, no matter what time you buy or sell.

ETFs also have some small tax benefits and can have lower minimum investment requirements compared to index funds.

For many investors, these difference don’t matter. However, if you want to have more control over the price of the fund, you may prefer ETFs. 

Building the Portfolio

Step 1: Figure Out Your Goals

If you want to reach financial success, you need to have a picture in mind of what financial success means to you. This means you have to decide what goals you want to accomplish in what timeframe. 

Do you want to save enough to pay for kids’ college? Do you want to retire at 60? Or do you want to save up enough for a down payment on a house? 

Having these goals in mind will help you answer these two questions: 

1. How much money do you need?
2. When do you need it?

These two questions are the main deciding factors in portfolio building. 

If your goal is really short term (less than 5 years from now), you probably can’t afford to risk losing everything you’ve saved up. In this case, you might want to allocate more of your portfolio in cash assets.

On the other hand, if your goal is long-term, you can probably handle the short-term market fluctuations to take part in big long-term growth investments. Here, you might want to put more of your portfolio in stock assets. 

On a similar note, if you need more money, you will have to take more risk to have a chance at meeting your goal (invest more stocks). However, if you don’t need much more money than you have now, you will probably want to take less risk (invest more in bonds/cash equivalents). 

Step 2: Determining Your Asset Allocation

Asset allocation means spreading your investments across various asset classes. Broadly speaking, it means to allocate your investment among stocks, bonds, and cash equivalents. 

Diversification is important because it protects your investments from disaster. Historically, the returns of the three major asset categories have not moved up and down at the same time. 

Market conditions that cause one asset category to do well often lead to another asset category having average or poor returns. By investing in more than one asset category, you’ll limit your losses and reduce the fluctuations of investment returns. 

Determining the appropriate asset allocation can be a complicated task. Basically, you’re trying to pick a mix of assets that has the highest probability of meeting your goal at a level of risk you can live with. So it depends on your goal, age, risk tolerance, etc. 

Remember that stocks historically have shown the greatest risk and highest returns among the three major asset categories. Bonds are generally less volatile than stocks but offer more modest returns. Cash equivalents are the safest investments, but offer the lowest return. 

You need to balance the risk and return by proportioning your investments among the three categories. 

Aggressive vs. Conservative

Here are some examples of asset allocations with progressively increasing aggressiveness:

A more aggressive portfolio means your goal is aiming for long-term capital gain, while a more conservative portfolio means your goal is aiming for protecting the principal value of your portfolio. 

There is a commonly cited rule of thumb that suggests subtracting your age from 100 to decide how your portfolio should be invested. If you’re unsure how aggressive or conservative you should make your portfolio, this rule of thumb is a pretty good estimate of what you should do:

If you’re 30, this rule suggests 70% of your portfolio allocated to stocks and 30% of your portfolio in bonds. When you turn 60, that mix shifts to roughly 60% allocated to bonds and 40% to stocks. 

It’s a simple rule of thumb, but gives you an idea of how your portfolio should change over time. If you want, you can always tweak it to be more or less aggressive depending on your goals. 

Step 3: Putting your Portfolio Together

Once you’ve divided up your asset allocation by the 3 major categories, you need to further allocate your investments in products within each category. 

Diversification is also key here. For example, you may divide the portfolio’s stocks portion between different industrial sectors and companies of different market capitalizations, and between domestic and foreign stocks. 

Some products like mutual funds can help you achieve diversification quickly, but you need to note if the mutual fund focuses on one particular industrial sector, location, or market capitalization. If so, you may want to purchase several different mutual funds to achieve the diversification you seek. 

It is recommended, especially to new investors, to use low-cost index funds, mutual funds, or ETFs for the bulk of your portfolio’s investments. These funds offer an easy way to achieve diversification cheaply. 

Investing through these investment vehicles also greatly reduces the mental overhead of picking individual stocks and bonds yourself. To be honest, these funds will probably do a better job at picking stocks/bonds than you would on your own. No one, not even the experts, can consistently pick the best performing stocks themselves.

Step 4: Rebalance and Reassess your portfolio

Rebalancing means bringing your portfolio back to your original asset allocation mix. This is necessary because over time some of your investments may become out of alignment with your investment goals. 

For example, if you determined that stock investments should represent 60% of your portfolio, but after a few years of growth, stock investments now represent 80% of your portfolio. You’ll need to either sell some of your stock investments or purchase investments from an under-weighted asset category in order to reestablish your original asset allocation mix. 

Reassessing means to go back steps 1 and 2 and review your portfolio. A lot of factors are likely to change over time, like your financial situation, future needs, and risk tolerance. If these things change, you may need to adjust your portfolio accordingly. 

Conclusion

Investing might sound intimidating, but all it really boils down to is determining how much you want to allocate to stocks, bonds, and cash equivalents. Each type of investment offers a different level of risk and reward. How much you put in each is all determined by your risk tolerance and financial goals. 

Here’s my recommendation: If you’re in your twenties or early thirties, put almost everything in some index funds/ETFs comprised mostly of stocks. You have a lot of time to recover from short-term fluctuations and to take part in big long-term gains. Of course, this is assuming you have an emergency fund in place, no major expenses coming up soon, and have your debts paid off. You can read my other post about that.

If you do choose to invest, make sure you diversify your investments appropriately. You can do that quickly and easily through index funds, ETFs, and mutual funds. Ideally, you should find one with low management fees. 

If you want to learn more about investing, check out my other post on stock market investing.