Step 1: Determining the Appropriate Asset Allocation for You
Ascertaining your individual financial situation and goals is the first task in constructing a portfolio. Important items to consider are age and how much time you have to grow your investments, as well as amount of capital to invest and future income needs.
An unmarried college graduate just beginning his or her career needs a different investment strategy than a 55-year-old married person expecting to help pay for a child's college education and retire in the next decade.
A second factor to consider is your personality and risk tolerance. Are you willing to risk some money for the possibility of greater returns? Everyone would like to reap high returns year after year, but if you can't sleep at night when your investments take a short-term drop, chances are the high returns from those kinds of assets are not worth the stress. Clarifying your current situation, your future needs for capital, and your risk tolerance will determine how your investments should be allocated among different asset classes.
The possibility of greater returns comes at the expense of greater risk of losses (a principle known as the risk/return tradeoff) – you don't want to eliminate risk so much as optimize it for your unique condition and style. For example, the young person who won't have to depend on his or her investments for income can afford to take greater risks in the quest for high returns.
On the other hand, the person nearing retirement needs to focus on protecting his or her assets and drawing income from these assets in a tax-efficient manner.
Conservative Vs. Aggressive Investors
Generally, the more risk you can bear, the more aggressive your portfolio will be, devoting a larger portion to equities and less to bonds and other fixed-income securities. Conversely, the less risk you can assume, the more conservative your portfolio will be. Here are two examples: one for a conservative investor and one for the moderately aggressive investor.
Conservative portfolio
The main goal of a conservative portfolio is to protect its value. The allocation shown above would yield current income from the bonds and would also provide some long-term capital growth potential from the investment in high-quality equities.
Moderately aggressive portfolio
A moderately aggressive portfolio satisfies an average risk tolerance, attracting those willing to accept more risk in their portfolios in order to achieve a balance of capital growth and income.