What is a Portfolio?

A portfolio is your investment pie…

Each asset represents a slice of the pie, whether it be stocks, bonds, mutual funds, exchange-traded funds (ETFs), cash, or something else. The slices are proportionate to the entire pie. For instance, if 50% of your portfolio were in stocks, the “stocks” slice would represent half the pie. As stock prices rise and fall, the size of that slice would grow or shrink accordingly.

A portfolio is a 30,000-foot view of your investments. It’s the big picture — the breakdown of all the stocks, bonds, and other financial assets you own. Ideally, your portfolio should help you achieve the best possible return given your risk tolerance. The mix of assets in your portfolio should be determined in part by your financial needs and how long you want to own each asset.

Portfolios can take many shapes, and sometimes they’re dedicated to just one asset class, like stocks or bonds. However, there are recommendations and best practices for what to include in your portfolio. These often depend on how much money you’re earning, when you plan to retire, your lifestyle, and your risk tolerance. Generally, when discussing their investment portfolio, a person doesn’t include items such as their home or car.

Portfolios provide a framework for your money. They’re built to help you oversee and manage your investments.

If you want, a portfolio can help you diversify* your assets, spreading them across stocks, bonds, and other purposes. Monitoring your portfolio by each asset class can help you determine whether your strategy is working for you. Over time, you might decide to buy more of certain assets, or sell others.

Sometimes, people use target allocations to plan for various goals. For example, with a financial planner, you might determine what percentage of your assets to invest in stocks versus bonds.

Building a basic portfolio can be as simple as buying a few stocks. Many people start there. However, research suggests that building a more intentional portfolio (one that helps optimize your returns, while effectively managing your risk) means including a variety of assets. The mix that you choose is known as your asset allocation.

There are three main ways to build an actual portfolio:

1. Pick individual assets yourself;
2. Invest in an actively managed mutual fund or exchange-traded fund; or
3. Hire a financial advisor to choose investments for you.

As mentioned, you can independently pick a collection of stocks. Or you might pick a mix of stocks and bonds. This assumes you’re investing on your own and building your own portfolio.

One alternative to picking your own stocks is to invest in an actively-managed mutual fund or exchange-traded fund (both of which can invest in a variety of assets).

Another possibility is hiring a financial advisor (someone who gives you advice on investing and money management) to set up a portfolio on your behalf.

Two keys to building a portfolio can be:

1. Knowing your risk tolerance, and
2. Understanding your time horizon.

These parameters can help begin to determine what types of investments you have in your portfolio. And typically, they work in tandem. For instance, investors with longer time horizons (e.g., people with more years until retirement) typically have a greater risk tolerance than short-term investors, who expect to sell their assets sooner.

High risk and a long time horizon Aggressive investors with longer time horizons tend to buy assets like stocks and real estate. That’s because these generally offer greater upside, although they’re often more volatile and risky as well.

Low risk and a short time horizon Conservative investors are more risk-averse. They usually prefer portfolios that prioritize financial stability and predictable returns. Oftentimes, conservative investors invest more of their money in income-oriented investments like bonds or dividend-paying stocks of larger, more established companies.

In its simplest form, risk is the chance that you’ll lose money. And depending on how much you hate losing money, you might figure out your “risk tolerance.” Are you conservative? Aggressive? Somewhere in between? Depending on your risk tolerance, you might choose your asset allocation so you can stomach the rises and falls of the market.

Individual stocks carry “specific risk.” This is the chance that something negative happens that affects one company (e.g., the CEO departs, a major supplier goes bankrupt, or there’s a product recall). Individual assets, like bonds, also have specific risk.

But there’s also a chance that a segment of your portfolio, or even your entire portfolio, could decline simultaneously. (This could happen during a recession, or if you’ve concentrated your investments in a single industry.) The risk associated with your entire portfolio partially depends on your asset allocation and it’s called “portfolio risk.”

A concentrated portfolio can be more volatile than a diversified one, and it runs the risk of falling more dramatically. That’s true of almost all assets — If you mostly invest in real estate, for example, and the real estate market falls broadly, your portfolio will probably decline more, too. This type of company- or industry-specific risk can potentially be reduced through diversification.

Your risk appetite is also likely based on how long it will be before you want to sell your assets. If you need or want your money sooner, you’re probably better off investing in more conservative assets. Generally though, if you have a longer time horizon, you might consider a more aggressive approach.The idea is that you might have more time to make up for any losses or near-term volatility.

How does this look in the real world? Well, digging deeper, individuals who hope to buy a house soon might pursue conservative investments, limiting their portfolio to less volatile assets. But younger investors saving for retirement might choose somewhat riskier assets. While stocks tend to offer more upside than bonds over the long-term, they usually encounter higher volatility, too, so you have to be comfortable seeing more losses from time to time. Your investment choices always involve trade-offs.

Over time, the price of some assets will rise and others will fall. As a result, your asset allocation is likely to change. For example, if stocks have been performing well relative to other assets, your portfolio might have a higher concentration in stocks (and a lower concentration in the other asset classes).

Rebalancing means shifting your portfolio back to your target allocation (or maybe revising that target allocation). Depending on your strategy, you may sell in areas that are overweight and buying in areas that are underweight. Rebalancing can help you build and maintain a portfolio that’s right for your risk tolerance.

By the same token, if stocks haven’t performed as well recently, they might be a smaller slice in your portfolio than you want. In that case, you might buy more stocks to get back to your target asset allocation.

A diversified portfolio can help you manage risk by spreading your investments across different assets. Typically, diversification helps reduce volatility and smooth returns. Putting all your money into a single asset class can put your portfolio at unacceptable levels of risk. For example, if you own only stocks and the stock market falls, your portfolio will likely fare worse than if you owned both stocks and bonds.

That’s because most bonds tend not to fall as steeply as stocks—different factors typically drive each asset class—and bonds usually provide a predictable source of income. With a diversified portfolio, even if some assets decline, in certain conditions your other assets could continue unaffected, helping to minimize your losses. This is not always the case, as under different conditions you can experience losses across the board.

The trick is finding assets that don’t move together. That is, if an asset is performing poorly, you might want one to counterbalance it. Diversification is kind of like planning your weekend to account for unpredictable events. If it’s sunny, you’ll go to the beach. But you might buy a board game, just in case it rains and you have to stay home. That plan is diversification in action.

Diversification doesn’t prevent losses, but it can help limit losses. Building a diversified portfolio typically involves a mix of stocks, bonds, and cash. Adding real estate, gold, currency, and other assets can bolster a diversified portfolio.

Even if you decide to only invest in stocks, you can achieve a measure of diversification simply by owning more than one stock. In the 1960s, stock market researchers found that as few as 10 stocks could help in the pursuit of diversification. That said, in contemporary times, many believe it takes more stocks to build a truly diversified portfolio.

In addition to diversifying across asset classes, an investor might want to diversify across market segments—for instance, across the auto industry and consumer staples. Furthermore, an investor might want a mix of companies in their portfolio, providing a balance of growth-oriented companies and older, dividend-paying companies. (Remember though, diversification does not ensure a profit or eliminate the risk of investment losses.)

No single asset allocation is perfect for everybody. What’s included in an individual’s portfolio will vary from person to person, depending on their situation and their goals. However, typical investments for a conservative investor might include a larger portion of cash and bonds, and smaller percentage of large, established companies.

More aggressive investors sometimes invest in small-cap stocks, growth stocks, or high-yield bonds. Others might pursue real estate and alternative investments, such as commodities and foreign currencies. In addition to the usual risks of investing, these add unique risks that require more research or the help of a professional.

*Diversification does not ensure a profit or guarantee against a loss.