Investing can feel overwhelming, with endless strategies and options for building a portfolio. Investing is not “one-size-fits-all” because everyone has unique goals, priorities, and risk tolerances. This guide will help you understand our research-backed approach to portfolio theory, focusing on what to invest in and how much risk to take on. We’ll cover the key principles of portfolio construction: diversification, cost, risk tolerance, and capacity.
How to diversify your portfolio
There are many types of investments you can choose from. One option is buying individual stocks and investing in companies such as Apple or Microsoft. While this could lead to significant gains, it can also lead to significant losses if the stock performs poorly. All investing risks the loss of principal. Investing in index funds provides more diversification than selecting individual stocks. Index funds bundle together numerous individual stocks or bonds. There are different indexes that track the performance of specific sectors in the market. For example, the S&P 500 is an index including 500 of the largest U.S. companies. Instead of investing directly in these companies, you can buy an index fund that invests in them for you. Generally, holding index funds is a simpler and less risky way to diversify your portfolio compared to picking individual stocks.
How can you control costs?
Investment strategies generally fall into two categories: active and passive management. Actively managed funds aim to outperform market indices (like the S&P 500), while passive funds aim to match those indices for stocks and bonds. Active funds rely on stock picking to outperform index funds. They are trying to forecast and anticipate market trends to pick stocks of different weights than the index. Due to this strategy, they tend to have higher fees because of management and research costs, and inherently greater risk- but higher returns are not guaranteed. Research consistently shows that passive funds outperform active funds when accounting for fees over long periods of time. This suggests that, on average, passive management offers higher net returns for your portfolio.
If you are interested in learning more about passive vs. active management, see the data here.
Determining your risk tolerance and capacity
Risk tolerance and risk capacity are crucial in deciding how much stock exposure to hold. Risk tolerance is your personal comfort with market fluctuations—how much risk you can stomach before feeling the urge to sell. Risk capacity reflects how much risk you can afford based on your financial situation. Both your risk tolerance and capacity should be considered when you make a decision about your portfolio’s asset allocation.
For example, you may have the tolerance for a 100% stock portfolio but lack the capacity if you need to access the money soon. Suppose you have $100,000 invested in stocks but need the same amount for a down payment on a home. If the market drops 20%, your portfolio will be worth $80,000, potentially jeopardizing your home purchase. On the other hand, if you have a larger investment portfolio of $1M, and you’re making the same purchase, the same market decline will leave you with $800,000. This is still a significant surplus to draw the $100,000 needed. In this situation, a market decline may be uncomfortable, but it won’t affect your ability to meet short-term needs.
Even if you have a high-risk capacity, it’s important to match your risk exposure to your personal tolerance. Selling in a market downturn can lead to poor outcomes. Historically, the United States market has come back, and avoiding emotional decisions is key to long-term success. However, there is no guarantee that markets will rebound in the future. Choose a level of stock exposure you can maintain through market fluctuations based on both your risk capacity and tolerance, whether it is 100% bonds, 100% stock, or anything in between.
How do you implement this?
Think about your short-term and long-term cash needs, along with your risk tolerance and capacity. Once you have made a decision on these items, consider looking for low-cost, well-diversified index funds. If you choose a 50/50 allocation between stocks and bonds, you could invest 50% in low-cost stock index funds and 50% in low-cost bond index funds. These funds can track U.S. or global markets and are available through well-known providers such as Fidelity, Vanguard, and Schwab. Investing doesn’t need to be complex; you can start with a simple, diversified portfolio as you continue learning about the market and portfolio theory and re-evaluate your goals, risk tolerance, and capacity over time.
For more information geared towards beginning investors, learn about your financial account options here.
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