Financial Education: Part 8 – Risk and Reward – Five Popular Portfolio Types
So, you’ve decided that you want to take a an active role in shaping your financial future; it’s a big step and often comes with a mixture of elation and trepidation; however, fear not, because you’ll never be short of sage advice from those that know just marginally more than you do.
This series of articles is peppered with rules of thumb and pithy one-liners to help you on your way and there is a good reason for that – they are well founded; if you apply them to your thought process as you grow as an investor, you shouldn’t go far wrong.
One that you’ll no doubt be served up, probably with a slightly sickly, knowing look, is ‘don’t put all your eggs in one basket’; that is Diversification 101 and the best way to mitigate risk and improve your chances of achieving a better return on your investment.
Spreading your investments around makes every sense; however, there are different ways to achieve this and the way you construct your portfolio will make a difference in terms of how it performs in different market conditions; in this article we look at five portfolio types, and how you might get started with each of them.
You’ll also no doubt have the risk/reward curve explained to you, but again, it’s totally pertinent; the higher the risk you take in your choice of investments, the higher your potential returns, but the higher the chance that you will lose money.
An aggressive portfolio includes investments with a high-risk/high-reward proposition; shares in this category are sometimes described as having a ‘high beta’ – they may consistently experience larger fluctuations relative to the overall market.
investments with a high-risk/high-reward proposition
Companies with aggressive stock offerings are often in the early stages of growth and may have a unique value proposition; this is quantified in a ‘beta coefficient’, so if a stock has a beta of 2.0, it will typically move twice as much as the overall market in either direction.
An investor looking to build an aggressive portfolio will have to do quite some digging to seek out such companies, because most will not be household names; don’t underestimate the challenge of finding companies with rapidly accelerating earnings growth before the City boys get a sniff of them.
The most common sector to scour has been technology, particularly in the US, but firms in many other sectors pursue an aggressive growth strategy.
However, building and maintaining an aggressive portfolio is not for the faint-hearted or the inexperienced and strict risk management is of paramount importance; keeping losses to a minimum and taking profit are keys to success with an aggressive portfolio.
Defensive stocks do not usually have a high beta score and are fairly isolated from general market movements; cyclical stocks, on the other hand, are those most sensitive to the underlying economic business cycle.
For example, companies that make the basic necessities tend to do better when the economy downturns than those focused on frippery; companies that make products essential to everyday life are likely to survive however how bad the economy gets.
Cyclical stocks offer a level of protection against detrimental events; the products and services of these companies are in constant demand regardless of the stage in the business cycle; many of these companies offer a dividend as well which helps mitigate any capital losses incurred in a falling market and a defensive portfolio is considered prudent for most investors.
An income portfolio aims to deliver positive cash flow by harvesting dividends or other types of distributions to stakeholders; these companies are similar to safe defensive stocks but should offer higher yields.
Real Estate Investment Trusts (REITs) are increasingly popular income-producing investments; property investment companies return a great majority of their profits back to shareholders in exchange for favourable tax treatment.
REITs are an easy way to invest in property without owning it, but these stocks are also subject to the economic climate; REITs can take a beating during an economic downturn, as building and buying activity slows.
a handy additional income stream, or perhaps be used to deliver income in retirement
An income portfolio can provide a handy additional income stream, or perhaps be used to deliver income in retirement.
Income investors should look for stocks that may have fallen out of favour but still maintain a high dividend policy; utilities and slow growth companies are a good place to start as they can deliver a useful combination of income and capital growth – dividends and increasing share price.
A speculative portfolio presents more risk than any of the others here and may be little more than a ‘punt’; however, those looking to inject a little excitement into their portfolio may be prepared to gamble with a small portion of their total wealth.
At the zenith of the risk/reward curve, speculative investments could include initial public offerings (IPOs) or stocks that are rumoured to be takeover targets, technology or health care firms in the process of researching a breakthrough product, or a junior oil company rumoured to be sitting on a gusher.
It could be argued that products such as leveraged ETFs represent speculation because picking the right one can deliver huge profits in a short period of time, but received wisdom is that if you are tempted to have a flutter you should not commit more than 10% of your overall to speculative investments.
To be managed successfully a speculative portfolio requires the most homework and monitoring; these are typically trades rather than buy-and-hold investments.
A hybrid portfolio may include other asset classes such as bonds, commodities and property or alternative investments such as art or fine wine; this is a flexible approach and a typical portfolio may include some blue chips, gilts or corporate bonds, mutual funds, investment trusts and REITS.
A hybrid portfolio would include a mix of stocks and bonds in relatively fixed proportions and further diversification can be achieved within the fixed asset class by buying bonds with differing maturity dates.
This approach offers diversification across multiple asset classes, which is beneficial because equities and fixed income securities tend to have a negative correlation whereby one will rise as the other falls.
Inevitably building your own investment portfolio requires more effort that simply investing in the readymade portfolio of a fund, buying a tracker, using an automated – robo advice – platform or buying a packaged solution such as a model portfolio or an IFISA.
somewhere between the sanctuary of a cash deposit and a hair-on-fire punt
It may be that you don’t consider this an all or nothing scenario and create and maintain a combination of these portfolio types to give you the risk and reward characteristics you want; somewhere between the sanctuary of a cash deposit and a hair-on-fire punt there will be an approach that gives you the right balance of upside potential and peaceful slumber.
If you decide to go it alone you will need to be more hands on than with other options and you will be required to monitor your portfolios and rebalance more frequently; additional diversification comes from operating more than one portfolio type and once you get to grips with the basics, defining and building a portfolio will increase your investing confidence, give you control over your finances, and ultimately deliver the investment returns you target – because that’s why you became a DIY investor in the first place.