Building a Balanced Portfolio
Despite what it looks like in the movies, the point of investing is not to experience huge wins overnight. That’s great if it happens, but for most investors, the goal is to build wealth over a long period of time, such as 30 or 40 years. The reason for this is simple — risk.
Investing risk and potential returns are correlated — so, the higher the risk, the higher the possible payoff. Someone with a very high risk tolerance, who doesn’t mind losing everything, might play the stock market actively, investing in the hottest, most cutting-edge companies, trying to read the trends to spot the next big thing.
An investor with very low risk tolerance might put everything they own in bonds and cash equivalents, despite the fact that their cash is steadily losing value, thanks to inflation. Most people fall somewhere in the middle. We don’t want to risk everything, but we want to see healthy, gradual growth in our investments.
What Can You Invest In?
Types of investments are called asset classes. Like any classification system, certain types of investments are lumped together because they have similar characteristics and are regulated in the same way. The core asset classes are:
- Equities (stocks, mutual funds): When you own a piece of something, like a company. Includes index funds and exchange traded funds (ETFs).
- Fixed income (bonds): When you join in with others to lend money and earn returns on the interest. Includes bonds issued by corporations and by the government.
- Cash equivalents (cash on hand, money market funds): These are highly accessible cash sources. Cash you could get quickly.
How Age Affects Balance
A balanced portfolio looks different depending on your investing goals and how old you are. If you are investing for retirement, your level of risk is based on when you want to retire. A younger person can take bigger risks because they have more time to recover from losses. A person closer to retirement wants safer investments so that they are guaranteed their money will be there when they need it.
One guideline that has been around for years is to subtract your age from 100 to find your best investment mix. So, if you are 30 years old, you would subtract 30 from 100 to get 70. That means you would invest 70 percent in riskier stocks and 30 percent in safer bonds.
However, these days, because we are all living longer, many advisors are using 110 as the base number. So, if you are 30 years old, you would subtract 30 from 110 to get 80, meaning you would invest 80 percent in stocks and 20 percent in bonds.
Other Ways to Diversify
Beyond a mix of asset classes, a balanced portfolio also spreads risk across a variety of stocks and bond funds in:
- Varying industries — Some riskier investments (growth stocks) and some safer ones (value stocks)
- Public and private — Some corporate and some government bonds
- Domestic and international
- Large and small shares
Once you’ve found a mix that feels right to you, the best advice is to leave it alone. Don’t obsess over every little loss. Don’t try to get on the bandwagon of every popular stock. The only thing as important as diversifying your portfolio is allowing enough time for your investments to grow.
About once a year, you should rebalance your portfolio to make sure it is still meeting your risk level. As you get closer to retirement, start nudging those investments toward the safer end of the spectrum.
If you want a very hands-off way to manage risk, you could invest in a target date fund, which is managed by a fund manager who automatically adjusts the risk to be safer as you get closer to your “target date” for retirement. Look for these funds as part of your 401(k) choices, but always watch for fees. Do some research into low-cost fund options and brokerages with minimum administrative charges.
A diversified, future-looking portfolio can set you up to have guaranteed income in retirement. It all starts with identifying your goals and getting clear about your finances. Want to learn more? Take SAM’s free Money Basics Investing course.
[Any reference to a specific company, commercial product, process or service does not constitute or imply an endorsement or recommendation by the National Endowment for Financial Education.]
See this article in Spanish: Cómo crear una cartera equilibrada