What’s a portfolio, and how do you build one?

So you’ve got your stockbroking account, you know how much you’re going to invest each month. Surely it’s time to buy your first stock?

Not so fast. There are very few sure things in investing, but I’ll tell you one right now.

When you invest, you will sometimes make mistakes. You will sometimes lose money. That’s why investments are called ‘risk’ assets.

The key is to make sure that none of those mistakes is catastrophic. So that in the end, the money you make far outweighs the amount that you lose.

Some sound investment advice from the Lord

There are lots of good investing habits that will help you to do this. We’ll be going through all of them in the course of this series.

But the first rule is: don’t put all your eggs in one basket. This may in fact be one of the oldest rules in investment.

In the Bible, in the book of Ecclesiastes, alongside some other handy tips, is this little gem: “Divide your investments among many places, for you do not know what risks might lie ahead.”

This is just common sense, of course. If you put all your money into one share (or one bond, or one commodity), then you are making a very big bet.

Even large blue-chip companies can suffer disastrous share-price falls. You only need to look at oil giant BP’s 2010 Gulf of Mexico disaster for recent examples of this happening. So of course you need to buy more than one stock.

But it goes deeper than that.

Say you buy BP and Shell and eight other oil companies. That gives you some protection against ‘stock-specific’ risk.

But what if the oil price collapses? Or someone comes up with a way to run cars on solar power or natural gas? Your whole collection of oil stocks is going to take a dive.

So as well as holding a range of stocks, you need exposure to a range of sectors.

But wait – there’s more.

There’s more to life than stocks

What if the ‘big picture’ is simply hostile to stocks as a whole? As a rule of thumb, for example, during periods of falling prices (or deflation), bonds tend to do better than stocks. If prices start to rise rapidly on the other hand (inflation), that’s toxic for bonds, but good for gold.

In other words, sometimes the best-performing assets are outside the stock market altogether. Indeed, over the last decade, you’d have been far better off favouring gold and government bonds rather than buying stocks.

So you need to build a portfolio of holdings that spreads your risk across a range of different companies, sectors, and asset types.

What’s the point of all this?

Some of you might be saying: what’s the point? If one half of my portfolio is going up when the other half is going down, how am I ever going to make any money?

It’s a good question. The basic answer is that while different asset classes may be affected by different factors at different times, that doesn’t mean that they act as precise mirror images of one another.

The point is not for moves in your portfolio to ‘cancel’ one another out. It’s to cut down on your risk, without damaging your returns.

The fact is that if you spread your eggs across various baskets, you can make as much money as if you’d just put it all in one single basket – but without running the risk of ruining yourself if your single bet fails to work out.

A chap called Harry Markowitz first proved this in the 1950s and ended up winning a Nobel Prize for it. It’s been described as “the only free lunch in finance”.

A Nobel prize plus an endorsement from the Bible? He must have been on to something.

By the way, the technical term for not putting all your eggs in one basket is diversification. And the technical term for deciding which baskets to put your eggs in, and how to spread them, is asset allocation.

What to do now

We’ll start looking at the features of various different asset classes next time. But for now, it’s time to take a look at your existing portfolio.

You can’t allocate your assets efficiently if you don’t know where they are. So get together all the paperwork relating to your worldly wealth: from pensions, to Isas, to stockbroking accounts, to spread betting.

There’s one question here that people always raise at this point, so I’ll answer it now: if you own the home you’re living in, I’d ignore that for asset allocation purposes. You have to live somewhere. So don’t consider your own home as part of your portfolio.

That’s not to say that there won’t be times where over-paying your mortgage is among the best investments you can make. By paying off debt, you get a guaranteed return after all.

And it’s not to say that there aren’t times when it’s better to rent than to buy. We’ll consider all this in a later email.

If you own an investment property, that’s different of course – it’s part of your asset allocation (you own it).

Now work out your asset allocation. Are you particularly heavily invested in one area (unless you’ve given asset allocation some thought in the past, you probably are)? And are there any sectors that you think you should have more exposure to?

And knowing what percentage of your wealth is exposed to which sectors, how comfortable do you now feel about the way your money is spread around?