By definition, an investment portfolio is a collection of monetary instruments that are traded in the financial markets to generate income.
Instruments for portfolios are typically selected from several asset classes. The top three classes in the list below are the main ones that most nonprofessional investors use. The other three require more specialized knowledge. For this reason, the general public is less familiar with them.
Cash Equivalents (Money Market) — instruments with short maturities (overnight to less than one year) that are used for borrowing and lending. Examples: U.S. treasury bills (T-bills), certificates of deposit (CDs), commercial paper, and municipal notes.
Equities (Stocks) — instruments that signify a degree of ownership in a company or track a portion of the equity markets such as a sector or index. Examples: Individual stocks and exchange-traded funds (ETFs).
Fixed Income (Bonds) — instruments that require the issuer to make fixed payments over a predetermined time period. Examples: U.S. government bonds, municipal bonds (munis), and corporate bonds.
Commodities (Futures) — instruments that govern the purchase and delivery of physical products. Examples: Wheat, cattle, sugar, gold, and oil.
Real Estate — instruments that facilitate investment in residential and commercial property, including land. Example: Real estate investment trust (REIT).
Currencies (Foreign Exchange) — instruments that enable simultaneous purchase of one currency and sale of another. Example: Euro and U.S. dollar (EUR/USD).
Unfortunately, many people dump their spare cash into one central investment. This investment could be a hot stock, CD, or mutual fund. By default, a single investment becomes an entire portfolio. When personal circumstances or market forces move in a counterproductive way, these people experience financial pain due to loss or they miss out on substantial income that could have been acquired through wiser investment choices.
Making money from investments is merely an aspiration. Profitable portfolio creation begins with a concrete plan. Ask yourself…What do I intend to do with investment profits? Do I want to pay for a car, fund college education, have money for retirement, or contribute to a special project?
The specific reasons for the existence of a portfolio can be numerous. Some may be associated with small financial goals. Others may represent larger dreams. Regardless of the reasons, successful portfolio development begins with intentional, intelligent, and careful planning!
Portfolio Principle #1
Unless you expect to win the lottery (not recommended), plan to make money.
In addition to planning, an equally important element of portfolio development is timing. When will investment profits be needed? Here, it is helpful to divide a portfolio into sections that are governed by different time horizons. This type of division affords maximum flexibility in management and serves as a general form of risk control. One portfolio section might be labeled as “Short-Term Investments,” a second one as “Medium-Term Investments,” and a third one as “Long-Term Investments.”
The specific length of time assigned to each section will vary, depending upon the desires of the investor. In general, though, it is important to initiate portfolio development with a clear understanding of the end game.
Portfolio Principle #2
Every investment has a beginning and an end. Before getting into an investment, you should know when you are getting out.
Note how the following investors applied planning and timing to their respective portfolios. Each person selected financial instruments with the intent of acquiring profits for specific uses during identifiable time periods.
Short-Term Investment. Bob was interested in speedy returns on his money because he wanted to buy an engagement ring for his girlfriend. When he saw that interest rates were rising, he put some cash into high-yield CDs. Since he was not sure how long rates would continue to rise, he was comforted by knowing that his time horizon for commitment was only a few months. He was also savvy enough to know that CDs would not be an optimal investment if interest rates began to fall.
Medium-Term Investment. Bill managed a large farm that produced corn. As part of a seasonal loan agreement with his bank, he was required to insure his crop against failure. Since Bill had experience with trading commodities, he acquired commodity instruments that would make money for him if weather conditions became unfavorable. (Note: If you are wondering how this was done, Bill sold short futures and bought put options on corn. These contracts increase in value as market prices decline.)
Long-Term Investment. Steve and Becky have two young children. They realize that college education is a large expense that will continue to get larger over time. As a result, they begin to construct a portfolio with individual stocks believing that they can add more assets later. Ultimately, they want to earn enough money from their investments over a 15-year period to pay for a large portion of their children’s education.
Even though retirement is a long way off, Steve knows that he should be planning for it. His employer offers several investment options for participating in a company plan. The fact that Steve is able to choose specific mutual funds and trade those funds in a limited way is an incentive for Steve to learn more about trading.
Portfolio management is a broad form of market participation. Since an investor maintains positions for weeks or months if not years, it can also be called position trading. Unlike day trading or swing trading, however, this type of trading focuses on long-term market analysis and involvement. It also maintains a noticeable sensitivity to asset relationships that exist within a portfolio.
In Lesson 2, we will learn that all investments are not equally important. The financial emphasis placed upon individual portfolio instruments is often related to the risk associated with each one.