How to construct a portfolio

Over the past few weeks, we've written a great deal about the different sorts of asset classes that you can invest in. But how do you go about putting all of these together? This is where we start to get into the art of portfolio construction.

What is a portfolio?

At its most basic level, a portfolio is just another way of describing a group of investments that you or someone else (a fund manager, say) owns. It can be used in a very narrow sense to cover just one asset. For example, an equity portfolio would contain only shares. However, portfolio' is also an umbrella term to describe all of the investments that you own: bonds, property, cash, commodities as well as equities. This is what we'll mainly be looking at here. The process of building your portfolio starts with the asset allocation.

What is asset allocation?

Asset allocation simply describes the decisions you make about how much of your money to invest in different types of assets in your portfolio. For example, you could put all of your money into one asset class, such as equities. But having a 100% allocation to one asset class isn't generally recommended for most investors. Instead, it makes more sense to split your money between different types of asset, according to your time horizon how long you are investing for and your risk appetite how much of a roller-coaster ride you can stomach (this is known as "volatility" in City jargon).

Over the long run, equities have produced the highest returns of all the major asset classes. For example, the latest Credit Suisse report on long-term returns found that, with dividends reinvested, UK shares returned 5.4% in "real" (inflation-adjusted) terms between 1900 and 2015.

By contrast, bonds produced a real return of 1.7% during the same period. However, equities have also been more volatile they've gone through greater ups and downs. For example, during the last financial crisis, the value of the US stockmarket fell by nearly 60%. That's not something you want to see happening to your equity-heavy portfolio if you're planning to retire the following week.

The beauty of diversification

This is where diversification comes in which is the investment world's way of saying: "Don't put all your eggs in one basket". You see, the bond, property and equity markets don't always behave in the same way, so by holding different asset classes, you can reduce risk without necessarily reducing returns. This phenomenon has sometimes been described as "the only free lunch in finance", and was formally described by Nobel prize winner Harry Markowitz who wrote about "modern portfolio theory" in the 1950s.

Perhaps the best way to think of diversification is to imagine a firm that sells umbrellas and ice cream. When it rains, umbrella sales will compensate for the fall in ice cream, and when it is sunny, the reverse will happen. As a result, the company will make money whatever the weather.

But how much should you invest in each different asset? It largely depends on your time horizon. A young person saving for retirement would probably invest a large amount of money in equities they have plenty of time to ride out any crashes. So they might have 75% (or even more) of their money in equities, 5% in gold, and 20% in bonds, say. An older person would look at having more in less volatile assets such as bonds (some types of bonds, at least) or cash.

As well as deciding how you are going to divide up your portfolio, you'll need to make a decision about how to manage it. Unless you are a highly knowledgeable, very hands-on investor, it makes sense to make the big decisions about your asset allocation perhaps once a year, then keep trading to a minimum. Even in an age of online trading, moving money around incurs fees, which reduce returns.

Rebalancing buy low, sell high

If you want to keep your asset allocation roughly constant you'll have to intervene occasionally by "rebalancing". Let's say you have a 50/50 split between bonds and equities. At the start of the year you put £10,000 in each. By the end of the year, your equities have fallen to a value of £9,000, but your bond holdings have grown to £13,000 (it's been an unusual year). To "rebalance" back to a 50/50 split, you'd sell £2,000-worth of bonds and buy £2,000-worth of equities. This is a useful way automatically to "buy low, sell high".

By rebalancing regularly (it doesn't need to be too often, once or twice a year, or when your asset allocation gets more than a set distance from your target) you'll avoid getting caught in bubbles and also tend to invest in assets when they're unpopular.