An investment portfolio can involve a collection of stocks, bonds, cash, funds and/or investment trusts. Creating and managing a portfolio involves more than just picking good investments as this article explains.

There isn’t a perfect portfolio which will suit everyone, so it is important to construct one which suits your financial goals and risk tolerance.

That means setting a suitable investment horizon (at least five years) and asset allocation plan. It comes down to deciding how much to put into riskier assets like shares and how much to allocate to less risky assets like bonds and cash.

TIP 1: MAKE A LONG-TERM ASSET ALLOCATION PLAN

Academic research has shown that asset allocation accounts for over 90% of a portfolio’s return. Building a sensible asset allocation plan is therefore key to achieving long term financial goals.

In a nutshell, this involves deciding how much you should put into one area such as shares versus another and then regularly reviewing it to ensure each asset class hasn’t moved beyond your target.

For example, if you had 80% in shares and 20% in bonds and the equity market slumped, you might find the value of your investment in shares has fallen to 70% and bonds have jumped to 30%. At this point you might want to rebalance – something we’ll discuss in more detail later in this article.

Over the years, one popular starting point for asset allocation has been to invest a proportion in shares equivalent to 100 minus your age. For example, if you are 30, this theory implies you should hold 30% of your assets in bonds and 70% in shares.

This would be a good starting point but it is not set in stone. Often, people younger than 60 might find they want a much higher weighting to equities than is suggested by the ‘100 minus age’ rule. Even someone approaching or just starting retirement might want to have more exposure to equities, albeit focusing on high quality companies.

An alternative way to think about asset allocation is to use target ranges. Let’s say 30-year Joanne decides her optimal shares target is 75%. Joanne knows share prices can move around a lot, so she creates bands around her ideal target to allow for price volatility. She decides to set a range for shares of 65% to 75%.

Only when her portfolio’s share weighting moves above 75% or below 65% will Joanne consider making changes to her asset allocation.

While historically the starting point for portfolios might have been 60% shares and 40% bonds, investment experts are increasingly shifting to a broader portfolio model that includes assets that have low or no correlation to equity markets. This might include infrastructure or property used for medical centres or care homes.

Rebalancing a portfolio will be discussed later in the article, but it is worth mentioning there are age-based funds sometimes called ‘target-date retirement funds’ available. These funds automatically adjust asset allocation and therefore risk in a portfolio as an investor gets closer to retirement.

The downside to these types of products is that they are designed to be ‘one size fits all’ and everyone’s needs and risk tolerance are different. Many funds switch investors into types of bonds which don’t provide much inflation-protection, which means your money won’t go as far in retirement if the cost of living keeps going up.

A lot of people also underestimate how long they will live – as the average life expectancy increases, so does the need to consider investment growth in retirement. Don’t think that generating an income from your investments is the only thing that matters with a portfolio once you stop working.

TIP 2: DON’T PUT ALL YOUR EGGS IN THE SAME BASKET

There aren’t any free lunches in investing, but one which comes very close is diversification. This means spreading investments across different sectors, industries and geographies.

The more varied a portfolio’s exposure to different economic drivers, the less individual stocks will move up and down together. In other words, some weave while others bob, reducing the portfolio’s overall volatility.

Academics have shown that owning between 20 and 30 shares (spread across industries) is enough to achieve most of the benefits of diversification. But at the end of the day, it is a case of personal choice.

However, one thing to keep in mind is that the more stocks you own, the more work is needed to keep track of breaking news and wading through earnings reports.

Famed investor Peter Lynch, who managed money for Fidelity in the 1980s and wrote the popular book One Up on Wall Street, populated his portfolio with hundreds of names, but he also had the advantage of having access to thousands of in-house analysts.

When starting a portfolio, it can seem a like a daunting task to reach a good level of diversification. Think about all the research required and the amount of capital needed to invest in at least 20 companies.

There is no need to panic though as instant diversification can be achieved using ETFs (exchange-traded funds) and index trackers to get exposure to stocks and bonds. Investing in bond funds is probably the most effective way for retail investors to invest in bonds because of the specialist knowledge needed.

To achieve exposure to thousands of shares across developed and emerging markets investors could consider the iShares Core MSCI World Acc ETF (SWDA) which has $44 billion of assets and an ongoing charge of 0.2% a year.

In the bond space investors could consider the Vanguard Global Aggregate Bond Acc GBP Hedged ETF (VAGS) which provides access to many different bonds at an annual cost of 0.1%.

Once a broad spread is achieved it means adding single stocks to a portfolio becomes less risky. It is all about maintaining balance, so it is worth monitoring sector weightings to ensure a portfolio is not too heavily weighted to certain parts of the market.

A guide to sector constituents for indices like the FTSE 100 can be found on the London Stock Exchange website. Consumer staples have the biggest weighting in the FTSE 100 at around 19% with financials making up 18%.

If you’re buying a fund, ETF or investment trust, the fact sheet will have a breakdown of the different sector exposures.

Stocks in the same sector tend to move together so there is no advantage in owning more than one or two names.

Once built and populated with the best ideas a portfolio effectively sets the bar for new investments. This may mean that the best use of new cash is to top up current holdings, ideally those which have underperformed as valuations could be more attractive than putting more money into ones that have done well.

TIP 3: KEEP COSTS AS LOW AS POSSIBLE

Because investing is a long-term venture even small annual deductions from capital can really add up over time, so keeping costs down can pay off.

Costs are varied and include transaction fees and platform charges. In some cases, you will also pay stamp duty and foreign exchange fees if buying overseas-listed shares, among other costs. You also need to consider the difference between the buy and sell price, which is called a ‘spread’. The smaller the company, the larger the spread can be.

For example, a large company such as oil giant BP (BP.) has a lower dealing spread than smaller AIM stocks such as posh mixer company Fevertree Drinks (FEVR:AIM). Effectively the dealing spread is a measure of the daily liquidity and tradability of a share.

At the time of writing, video games maker Team17 (TM17:AIM) has a dealing spread of 3.2% which means for every £1,000 pounds of investment an investor incurs spread costs of £32 (assuming a purchase and eventual sale).

Investors who want to trade smaller-cap companies may find it more practical to invest via funds. Not only does this reduce individual stock risk but fund managers may be able to negotiate tighter bid/offer spreads due to their size.

The same reasoning holds for other specialist areas of the market such as biotechnology, technology, and overseas markets. The downside is that specialist funds may charge higher annual fees.

It is also worth noting that scale is important in the investment world which means bigger funds can manage assets more efficiently and potentially offer lower fees.

More trading activity incurs more costs. Studies have shown that active fund managers who churn their portfolios less frequently outperform managers who make more changes.

One final point to consider is the impact of commissions on trading shares. Let’s say a fund platform charges £9.95 per trade. If you bought £100 worth of shares, your transaction fee would equate to approximately 10% of the value of the shares which is high. If you were able to afford a larger investment, the proportion of the dealing cost would fall.

For those who only have a small amount of money, it is more economic to consider investing in funds as dealing costs are typically £1.50. The alternative is to find a share you like and set up a regular investment, buying the same stock each month as most platforms will offer a discounted dealing fee in the region of £1.50 per trade for this service.

SHARES VERSUS BONDS

Historical data over the last 100 years tells us that shares have delivered higher returns than bonds and cash. The downside is that share prices often move up and down a lot which means they can generate losses over shorter time horizons.

How each investor mentally handles the down periods should be a good guide to their appetite for taking risk.

While history can be a guide, it is not perfect and the recent patchy performance of bonds is a good reminder of the dangers of relying too much on the past.

Government bonds have historically provided ballast to portfolios in times of market stress. But the post-pandemic years have not played out that way with bond prices set to inflict an unprecedented third consecutive year of losses on investors.

The culprit has been the rapid rise in official interest rates (bond prices moves in the opposite direction to yields) as central bankers fight sky-high inflation.

The good news is that yields (the bond coupon as a percentage of bond price) are at their highest since the late 1990s in the UK. This means investors can lock in yields of 4.5% from UK government bonds with a 10-year term.

Investing in government bonds from developed markets such as the UK is considered safe and usually means investors get the face value of the bonds back in full at maturity.

TIP 4: KEEP REBALANCING TO A MINIMUM

In essence rebalancing is about managing risk rather than maximising return. Annual monitoring of the overall shape of a portfolio is probably enough for most investors to keep on top of things.

It might be tempting to tinker with a portfolio, but as discussed trading doesn’t come free which means adding costs without much benefit.

Over time some stocks and sectors outperform and others underperform, which means relative weightings in a portfolio will change. This will also change the way a portfolio behaves.

If sector weights become out of kilter or some stocks have become a much bigger proportion of the overall portfolio (say close to 10%), it suggests a rebalancing may be necessary.

Investors with a regular savings plan which feeds cash into their portfolio can take advantage of natural rebalancing by using the new cash to top up underperforming parts of the portfolio, assuming the investment case is still intact. This has the advantage that it saves on paying commissions incurred when selling one share to buy another.

Three hypothetical portfolios

JANET: 25 YEARS OLD

Janet is a 25-year-old software programmer and is only a few years into her investment journey. Her portfolio is kept simple as she only has a small amount to put away each month.

Rather than spreading tiny amounts across five to 10 investments, she decides to put the majority into a global equity tracker fund and the rest into a global bond fund. As she gets older and earns more money, Janet plans to add more funds to her portfolio.

For now, Janet has chosen exchange-traded funds, also known as ETFs, as they are low-cost and she can take advantage of her investment platform’s discounted regular dealing service to get a low monthly transaction charge of £1.50 per item.

While some of her friends of the same age are happy to put 100% of their investments in equities, Janet is cautious by nature and prefers to have some bond exposure to spread her risks.

DAVID: 45 YEARS OLD

David is a 45-year-old teacher and intends to retire at 66. He has 65% of his portfolio in equities, just over half of which is held in a global equity tracker fund.

Given he still has more than 20 years until he plans to retire, David wants to grow his portfolio as much as possible and is happy to take on some extra risk by having a dedicated emerging markets fund.

David has the same amount held in an ETF that tracks a basket of quality companies paying dividends, with the income automatically reinvested so he enjoys compounding benefits.

His portfolio also includes a few bond funds, a commercial property fund and a global infrastructure/renewable energy fund to provide diversification.

KAREN: 60 YEARS OLD

Karen is a 60-year-old architect and intends to retire in five years’ time. She has started to dial down the risk in her portfolio ahead of time, albeit while keeping some pockets of higher-risk investments with the goal of having capital growth well into retirement.

Forty percent of her portfolio is spread equally across two equity funds: one features quality companies paying dividends and the other is a broad global growth and income fund. In both cases she currently holds the accumulation version of the fund so dividends are automatically reinvested. Karen intends to switch to the distributing version of each fund when she retires so dividends are paid out in cash. A similar strategy is in place for some of the other funds in her portfolio.

The bond component adds up to 25% of her portfolio but Karen intends to increase this weighting over the next few years to at least 35%. Elsewhere, she holds a few alternative assets on the basis they have low correlation with the markets.

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