How to Build an Investment Portfolio in the Right Order
To build an investment portfolio, decide what the money must do before deciding what to buy. The wider asset-building process starts with liquidity needs. Then define the goal and time horizon, assess risk capacity and risk tolerance, choose an asset allocation, diversify, select investments and review the result.
There is no single portfolio that suits every investor. The mix depends on when you need the money, how much loss your finances can absorb and how you are likely to respond when investments fall in value.
Use this order:
- Separate money that must remain available.
- Define the goal and time horizon.
- Assess risk capacity and risk tolerance.
- Choose the asset allocation.
- Diversify across and within asset classes.
- Select accounts and investments.
- Review the plan and rebalance when needed.
Which money should remain liquid before you invest?
Keep money for bills, emergencies and planned near-term spending liquid. Money that will not be needed during the investment period can move to the next portfolio decision.
The cash reserve you need depends on your circumstances. Income stability, dependents, debt payments and expected expenses can all affect the amount. A separate saving-versus-investing decision can help you determine how much money is available for investment.
How do your goals and time horizon affect the portfolio?
Your goal defines what the portfolio must achieve. Your time horizon is the period before you expect to use the money. These two decisions affect how much short-term loss the portfolio can reasonably accept.
Money for different goals may need different treatment. Retirement several decades away and a home purchase planned within a few years have different time horizons. A longer horizon can provide more time to recover from a market decline, but it does not remove the risk of loss.
| Portfolio decision | Question to answer | Effect on the portfolio |
|---|---|---|
| Liquidity | When could the money be needed? | Determines how much should remain available |
| Goal | What must the money achieve? | Defines the portfolio’s purpose |
| Time horizon | How long can the money remain invested? | Affects how much volatility it can face |
| Risk capacity | How much loss can your finances absorb? | Places a limit on portfolio risk |
| Risk tolerance | How much price movement and loss can you accept? | Affects your ability to follow the plan |
| Asset allocation | Which assets should perform each role? | Affects expected risk, liquidity and return |
| Review | Have your needs or holdings changed? | Shows whether an adjustment is needed |
What is the difference between risk capacity and risk tolerance?
Risk capacity and risk tolerance cover two different limits. Risk capacity is your financial ability to withstand losses. Risk tolerance is your willingness to experience uncertainty and falling values without abandoning the plan. The portfolio needs to stay within both limits.
Capacity depends on factors such as income stability, spending needs, debt, time horizon and reliance on the invested money. Tolerance concerns how you are likely to react during a market decline. A willingness to accept large losses cannot increase your financial ability to absorb them.
How do you choose an asset allocation?
Choose an asset allocation by deciding how much of the portfolio to place in broad asset categories such as stocks, bonds and cash. Each category has different risks, return potential and access to money.
Stocks can provide long-term growth but can experience large price changes. Bonds can provide income and may reduce some of the portfolio’s price movement, although they also carry risks. Cash provides easier access to money but may lose purchasing power over time. Property and other assets may also be considered, with their roles assessed separately.
No fixed percentage suits every investor. The allocation should follow from the goal, time horizon, liquidity needs, risk capacity and risk tolerance. Choose specific funds or securities after setting these limits.
How should you diversify your investment portfolio?
Diversify an investment portfolio across asset classes and within each asset class. This reduces dependence on one investment, company, sector, country or asset category.
Mutual funds and exchange-traded funds can make diversification easier because one fund may hold many investments. A fund can still be concentrated if it follows one sector, theme or narrow market. Check its underlying holdings and its overlap with the rest of the portfolio.
Diversification can reduce the risk of relying too heavily on one investment or asset category, but it cannot prevent every loss or guarantee a positive return. The guide to diversifying your portfolio can help you decide which investments and asset groups to combine and which risks will remain.
How do you put an investment portfolio into practice?
Putting a portfolio into practice means choosing accounts and investments that match the target allocation. The account should suit the goal, and each investment should have a clear role in the portfolio.
Check what each investment owns, how widely it is diversified, how easily it can be sold and what it costs. Fees reduce investment returns. Several funds may also hold many of the same securities, leaving the portfolio more concentrated than the number of funds suggests.
A portfolio with few holdings can still match its target allocation. Keep the holdings limited to investments you can understand and maintain.
When should you review and rebalance your portfolio?
Review the portfolio when your circumstances change or when its allocation moves away from the target. Rebalancing returns the holdings to the chosen allocation. A change in your goal, time horizon or ability to take risk may require a new target.
Start the review with your financial needs. Check the goal, withdrawal date, liquidity needs, income, financial commitments, risk capacity and risk tolerance. Then check changes from the target percentages, concentration, overlapping holdings and costs.
You may be able to rebalance by directing new contributions toward assets below their target percentage. Other cases may require purchases or sales. Consider transaction costs and possible tax consequences before trading. The review timing should match your plan and circumstances.