How to build your investment portfolio

Investing can bring you a great deal of potential returns, but let's not forget about the risk that comes with it too. All investments carry a degree of risk that's an important principle to always keep in mind.

Building a financial portfolio involves combining different investment assets to maximise your returns and minimise your risk. You want to find an optimal balance that's right for your risk appetite and financial goals.

While you can't completely eliminate investment risk, you can certainly manage it. The best way to navigate risk is to develop a diversification strategy for your investment portfolio and not rely on one single product or family of products for returns.

Here are some steps you can take to diversify your portfolio.

A well-diversified financial portfolio should include funds, stocks/securities, bonds, and of course, cash. Get to know these different types of investment tools and the investment risk levels they carry, weighing all of that against your own risk appetite and how long you want to be investing. We'll go into more detail on asset allocation later.

The cash portion of your portfolio should amount to 3-6 months' worth of your living expenses. This is called your emergency fund, which acts as a buffer for you in case something unexpected happens.

Unit trusts, exchange-traded funds (ETFs) and index funds are great ways to introduce diversification to your portfolio. With a unit trust (or mutual fund), a fund manager will help invest your capital in a diversified selection of securities, while an ETF gives you a bundle of securities you can trade on an exchange the way you would buy or sell stocks.

An index fund, on the other hand, is a type of mutual fund that aims to track the performance of a chosen financial market index like the Hang Seng Index, S&P 500 or the Dow Jones Industrial Average. A portfolio that invests in all or part of the constituent stocks (or constituent bonds) of that index would then be created.

With these asset types, your money is automatically spread over a selection of securities from a variety of companies, instead of just one. That way, you're not at the mercy of the rise and fall of one particular stock, and your risk exposure would be more spread out.

Picture this: you've got a passion in property and because of this, your portfolio consists solely of 10 of the biggest property companies in Hong Kong. But suddenly the government announces a new policy affecting land auctions that causes the city's property companies' stocks to plummet.

Even though you've technically spread your risk out by owning more than one stock, they're all the same type of stock, so they're positively correlated – they tend to trend the same way.

A better diversification strategy is to look for assets that are negatively correlated. This means if one asset declines, the others are likely to remain stable or might even see a boost in value.

If diversifying within a single asset class is a good idea, then diversifying across asset classes is a great idea. Instead of just sinking your money into stocks, you could consider adding bonds to your portfolio, because in general, when stocks go down, bonds may not necessarily go down (and vice versa). Of course, there is always the possibility that both asset classes can go down (and up) at the same time, but picking different asset classes for your portfolio will generally go a long way to help you alleviate some investment risk.

Choosing investment assets with different return of investment (ROI) rates is a good idea to both mitigate risk and optimise returns. That way, you may be able to use the larger gains from higher yield investments to offset any losses that other assets in your portfolio may bring.

You're probably familiar with stocks and perhaps even bonds, but those aren't the only investment options out there. You could start looking at alternative asset classes to diversify your portfolio. Consider gold for instance - it's what you'd term a 'safe haven investment', a type of investment that is expected to maintain or even climb in value during periods of economic volatility or when the market is softening. If you're looking for diversification and to mitigate your risk exposure, gold could be a good idea. Apart from investing in physical gold, you can also think about related products such as paper gold and gold exchange traded funds (ETFs), which are benchmarked against physical gold prices.

Being crystal clear about your current risk appetite will help you decide how you allocate your capital across asset classes.

Of course, these are just examples. They illustrate the very different asset allocation outcomes that are possible. That's why it's so important for you to do an analysis of your risk appetite and financial goals.

An asset allocation method that is gaining increasing popularity is lifecycle investing, a strategy developed by economists Ian Ayres and Barry Nalebuff¹. It's a strategy that helps you adjust your asset allocation as time goes by. It's based on the principle that a younger investor with a longer financial investment horizon would be able to take on more risk than an older or middle-aged person.

Basically, you subtract your age from 100 (they assume a person's lifespan to be 100 years) to determine your asset allocation split. So if you're 23 years old; your asset allocation would be 100-23 = 77, which would produce a portfolio that is 77% made up of stocks/funds and 23% bonds. Your 55-year-old mother, on the other hand, would be looking at a portfolio that is 45% stocks/funds and 55% bonds.

Naturally, this is a good yardstick, but it's not a method that's set in stone and you still have to examine your personal attitude towards risk and the financial aspirations you have, in order to pick the most suitable assets for your portfolio.

Decided on the combination of assets to kick-start your investing journey? Awesome job! But this isn't the end of it. You should always keep tabs on your portfolio and check to see how it's performing, or have your fund manager provide regular updates on your returns. This will help you see clearly if your portfolio is still in line with your risk appetite and ultimate financial goals, and allow you to make changes to your investments accordingly.

1 "Lifecycle Investing: A New, Safe, and Audacious Way to Improve the Performance of Your Retirement Portfolio", Ian Ayres and Barry Nalebuff, published 2010

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