Investing can be complex, confusing, and it’s constantly changing.
Hopefully, you know why you should invest and even if you don’t know the basics, investing for beginners will get you on the right track.
Your number one goal should be to build a portfolio that suits your needs. You probably have a certain risk level you would like to stay under, but you also probably have a certain amount of money you would like to make. Inevitably you will have to sacrifice one for the other. Overall, your portfolio’s goal should be to balance risk and return so you can reach your personal financial goals. So how do you build a portfolio?
Let’s start with the basics.
Decades of research reveal that over long periods of time, stocks outperform bonds, small companies outperform large companies, and value companies outperform growth companies. This all makes sense because risk and return are always linked.
- Stocks are more risky than bonds, therefore the investor should expect more return. This is called the equity (fancy word for stocks) risk premium.
- Small companies can double, but they can also go out of business. They are riskier than large companies. This is called the size premium.
- Value companies are companies that tend to have strong balance sheets and low stock prices relative to their book price, for example Ford. Growth companies are companies that are expected to grow their revenue earnings faster than most , for example Google. (I know it’s complicated, but that’s the best way I can explain it). This is called, you guessed it, value premium.
You have the chance of increasing your returns over long periods of time by over-weighting your portfolio to small-value stocks. Of course, because of diversification you want to own a lot of everything so don’t think you can get away by just purchasing small-value.
Let’s jump into your individual portfolio.
The first large decision you need to make is: how much risk am I willing to take?
There are a lot of great “Risk Tolerance” questionnaires and interviews out there. I suggest Googling for the same.
Depending on your answers, you need to be able to translate your risk level to a percentage of stocks in your portfolio. Usually more aggressive individuals invest into more stocks, conversely more conservative people invest into more bonds.
The second decision you need to make is: how much of your portfolio should be in small-value stocks?
Remember, small-value stocks are risky, but over long periods of time they can produce a higher return. If you have a longer time period, it may make sense to invest more into small-value stocks. However, everyone’s situation is different so you should consult with a professional advisor.
The last decision you need to make is: should you use conventional management or index funds?
If you truly believe someone can predict the future, go for conventional management. However, costs are a drag on performance, so by lowering costs you give yourself a better opportunity to reach your goal. Index funds usually have lower costs. Let’s look at the math:
The S&P500 returns 10%. Conventional management method’s made 10% as well, and the expenses were 0.75%. You, the investor, take home 9.25%. Index fund also made 10%, and the expenses were 0.05%. You take home 9.95%. Fees can be a significant drag on performance.
Ultimately, Your success depends on you
No matter how well you invest or how great your portfolio may be, you can’t turn $0 saved into $1 Billion. You will never be able to control how the stock market reacts or how much money a company makes. You need to focus on what you can control.
You can control the expenses you pay to invest, how well you diversify, how much you save, and how disciplined you are.
Working with a financial advisor to help you create a plan that allows you to reach your goals can truly benefit you. Advisors help keep you accountable and allow you to see the long term picture instead of the short term.