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How to Invest in the Perfect Portfolio

Cut through the confusion and build a winning investment portfolio.

By
Laura Adams, MBA,
August 21, 2012
Episode #280

How to Invest in the Perfect Portfolio

A Facebook follower named Murray H. says:

“Loved your book, Money Girl’s Smart Moves to Grow Rich! Your simple approach to money matters turned my life around. Can you help me understand which mutual funds to buy if I want to retire in 25 years?”

As you plan for retirement, picking the right investment funds can be confusing because there are thousands of choices. Today I’ll give you 3 tips to pick perfect investments and build a winning portfolio.

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Tip #1: Diversify

Many people are surprised to learn that it’s better to own more investments than less. This is a common investing strategy called diversification. It allows you to earn higher average returns while reducing risk, because it’s not likely that all your investments could drop in value at the exact same time.

For instance, if you put your life’s savings into one technology stock and it tanks, you’re in trouble. But if that stock only makes up a fraction of your portfolio, the loss is negligible. Having a mix of investments that respond to market conditions in different ways is the key to smoothing out risk. Diversification isn’t a guarantee that you’ll make a killing with your investments, but the idea is that as some investments go up in value, others may decline and vice versa.

If you’re thinking that building a diversified portfolio sounds difficult or time-consuming, don’t. Buying shares of a mutual fund or an exchange-traded fund (ETF) is a simple, effective, and inexpensive way to get diversification.

Funds bundle combinations of investments in stocks, bonds, assets, and other securities into packages that are convenient for investors to buy because they’re already made up of many underlying investments. Some funds may focus on one particular asset class only, like international stocks. To diversify further, the next tip will help you choose a mix of funds that’s best for you.

Tip #2: Consider Your Risk Tolerance

Investors always have to think about how comfortable they are with financial risk. Being risk-tolerant means that you’re willing to see the value of your investments go up and down quite a bit in the short term in order to achieve higher gains in the long term. Being risk-averse means that you’re conservative and would rather avoid a financial roller coaster—even if you have to sacrifice potential future gains. 

Adjusting your portfolio so you have the right mix of investments for factors like your risk tolerance, age, and goals, is called asset allocation. Investments fall into 3 main asset classes:

  1. Stocks: offer the most return and the most risk

  2. Bonds: offer lower returns for less risk

  3. Cash: offers virtually no return for no risk

It’s been shown that the majority of earnings from a given investment portfolio comes from how it’s divvied up into asset classes. There’s a rough rule of thumb that says you should own a percentage of bonds equal to your age. For instance, if you’re 40, you would own approximately 40% bonds and 60% stocks and cash.

In my book, Money Girl’s Smart Moves to Grow Rich, I recommend a variation on this rule that’s a little more aggressive: Subtract your age from 110 to find the percentage of stocks to own. For a 40-year-old, this method shows asset allocation of 70% stocks and 30% bonds and cash.

These investment allocation targets are not hard rules because everyone is different. To design your ideal allocation strategy you can use an online resource, like the Asset Allocation Calculator at bankrate.com.

What’s important to remember about asset allocation is that it should change over time. Take advantage of as much growth as possible in the early years by investing mostly in stocks. You’ll have plenty of time to recover from market losses. By the time you move into retirement, you should own fewer stocks and have more in bonds and cash to preserve the wealth you’ve worked so hard to accumulate.

You can even put your asset allocation on auto-pilot by investing in a type of mutual fund or ETF called a target-date fund. It holds a variety of asset classes and rebalances percentages automatically as market conditions change. You still need to be aware of what investments you own in a target-date fund, so you know if it’s the right mix for you, especially as you approach retirement.  

Tip #3: Compare Fees

No matter if you’re choosing investments from a large fund family—like Vanguard or Fidelity—or from a limited 401(k) menu at work, comparing fees is very important. Fees cover a fund’s operating expenses and they typically range from a tenth of a percent up to several percent.

Paying high fees can destroy your investment returns. Let’s say you invest $400 a month for 30 years in a fund that earns 8% on average, but charges fees of 2%. You’d amass just over $400,000. But if you chose a similar fund that charges just 0.5%, you’d save 1.5% in fees and end up with close to $540,000 in your account instead!

Exchange-traded funds (ETFs) are similar to mutual funds, but offer some advantages. One of them is that ETFs charge low fees. They trade on an exchange throughout the day, just like a stock, and operate in cyberspace without much overhead. Mutual funds, on the other hand, are purchased through a traditional fund company with higher operating costs, such as management, staff, and physical locations. So consider investing in ETFs instead of mutual funds where possible.

If you participate in a retirement plan at work or need help getting started, set an appointment with your benefits administrator. If you don’t have an employer plan or are self-employed, get help from an adviser at a brokerage firm or mutual fund company. They can show you how easy it is to build a perfect portfolio that’s diversified and tailored to meet your financial goals.

More Articles and Resources You Might Like:

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Photo attribution: Hand Drawing Chart photo from Shutterstock

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