An investment portfolio is simply a collection of investment assets. Once the portfolio is established, it is updated or “rebalanced” by selling existing securities and using the proceeds to buy new securities, by investing additional funds to increase the overall size of the portfolio, or by selling securities to decrease the size of investment portfolio.
Investment assets can be categorized into broad investment asset classes, such as stocks, bonds, real estate, commodities, and so on. Investors make two types of decisions in constructing their portfolios. The investment asset allocation is the choice among these broad asset classes, while the security selection decision is the choice of which particular securities to hold within each investment asset class.
The decision to mix and determine which of asset allocation to hold in your investment portfolio is a very personal choice or preferences one. You should realize that asset allocation that works best for you is depend on other things. Most of the time it will determine with your time horizon of investing and your risk tolerance.
There are 2 main approach to build investment portfolio: top-down and bottom-up strategy. A “top-down” portfolio construction starts with investment asset allocation. One individual who currently holds all of his money in a bank account would first decide what proportion of the overall portfolio ought to be moved. Either if he/she want to put it into stocks, bonds, and other investment vehicles which suitable. By doing this, the broad features investment portfolio are established. For example, while the average annualized return on the common stock of large firms since 1920s has been about 11-12% per year, the average return on U.S. Treasury Bills has been only 3.8%. Then again, if you compare stocks and US Treasury Bills, stocks are more riskier, with annual returns that have ranged as low as 46% and as high as 55%. Treasury Bills in contrast, may have returns that are effectively risk-free. When you opted for U.S Treasury Bills, you know what interest rate you will earn when you buy one.
Therefore, the decision to allocate your investments to the stock market or to the money market where Treasury bills are traded will have great ramifications for both the risk and the return of your investment portfolio. A top-down investor first makes this and other crucial investment asset allocation decision before turning to the decision of the particular securities to be held in investment asset classes.
Security analysis involves the valuation of particular securities that might be included in the portfolio. For example, an investor might ask whether Merck or Pfizer is more attractively priced. Both bonds and stocks must be evaluated for investment attractiveness, but valuation is far more difficult for stocks because a stock’s performance usually is far more sensitive to the condition of the issuing firm.
The “bottom-up” strategy had a contrast approach compare to top-down approach. In this process, the portfolio is constructed from the securities that seem attractively priced without as much concern for the resultant asset allocation decision. Such a technique can result in unintended bets on one or another sector of the economy. For example, it might turn out that the investment portfolio ends up with a very heavy representation of firms in one industry, from one part of the country, or with exposure to one source of uncertainty. However, a bottom-up strategy does focus the portfolio on the assets that seem to offer the most attractive investment opportunities.
Please take note one the main principles of investment before deciding your investment asset allocation. It is about risk and reward. When it comes to investing, risk and reward are inextricably knitted. You have probably learned the phrase: no pain, no gain. This phrase is totting up risk and reward relationship. You should not let anyone tell you differently: All investments involve some degree of risk.
