How to Build a SMART Investment Portfolio
By David S. Chang
Like every investor, you want to choose investments that will provide the growth and income you need to meet your financial goals. To do that, it’s important to understand yourself as an investor. That’s because a portfolio that’s right for someone else may not be best for you. Here are factors on How to Build a SMART Investment Portfolio:
- Your age
- Your goals, or what you want to accomplish by investing
- The time frames for your various goals
- Your attitude toward risk—or what’s called your risk tolerance.
You should also understand the ideas of asset allocation and diversification. Only then should you consider what your investment choices are and how different types of investments put your money to work. Your risk tolerance, asset allocation, diversification and rebalancing are critical components of your portfolio. Click below to get more information:
Investing for Different Time Periods
Part of setting investment goals is determining when you will need the money to pay for them. Your investment strategy will vary depending on how long you can keep your money invested. Most goals fit into one of three categories—short-term (less than three years), medium-term (three to ten years) and long-term (more than ten years).
Short-Term Goals (Less than Three Years)
Because you plan to spend the money you set aside for short-term goals relatively quickly, you’ll want to focus on safety and liquidity rather than growth in your short-term portfolio. Insured bank or credit union accounts as well as Treasury bills backed by the government’s promise to repay are generally considered safe investments. Liquid investments are those you can sell easily with little or no loss of value, such as Treasury bills, money market accounts and funds, and other low-risk investments that pay interest. If those investments have maturity dates, as T-bills do, the terms are very short.
For example, say you’re saving for a down payment on a house that you hope to buy in about a year. If you’ve invested the money in stock funds and your portfolio fell sharply just as you were about to start your home search, you might have to postpone your plans to buy, or choose a less expensive home. On the other hand, if you had given yourself a little more time to accumulate the funds for a down payment and invested them in liquid cash investments or insured bank products such as certificates of deposit (CDs), you could be more confident that the money you need would be available when you were ready to make an offer.
Cash investments typically pay lower interest rates than longer-term bonds—sometimes not enough to outpace inflation over the long term. But since you plan to use the money relatively quickly, inflation shouldn’t have much of an impact on your purchasing power. And keep in mind that some cash investments offer the added security of government insurance, such as bank money market accounts and CDs, which are both insured by the Federal Deposit Insurance Corporation. U.S. Treasury bills are another choice for short-term goals. Because they mature in 13 or 26 weeks and are issued by the federal government, they’re sometimes described as risk-free investments.
Medium-Term Goals (Three to Ten Years)
Choosing the right investments for mid-term goals can be more complex than choosing them for short- or long-term goals. That’s because you need to strike an effective balance between protecting the assets you’ve worked hard to accumulate while achieving the growth that can help you build your assets and offset inflation. Here are possible strategies for managing a portfolio of investments for goals that are three to ten years in the future:
- Balance your mid-term portfolio with a mix of high-quality fixed-income investments—such as a mid-term government bond fund or high-yield CD—with modest growth investments, such as a diversified large-company stock fund. Then monitor the stock investments closely and be prepared to sell to limit your losses if there’s a major market downturn.
- Establish limits for gains and losses in your mid-term stock portfolio. For instance, you may decide ahead of time that you’ll sell an investment if it increases in value 20 percent or decreases 15 percent—or whatever percentage you’re comfortable with. As your goal approaches, you can reinvest your assets in less volatile investments.
Balanced funds, which usually invest in a mix of about 60 percent stock to 40 percent bonds, growth and income funds, or equity income funds that invest in well-established companies that pay high dividends, might be appropriate choices for a mid-term portfolio. Ultimately, the key to achieving modest growth while minimizing risk is to keep a close eye on performance and gradually shift to more stable, income-producing investments as the date of your goal approaches.
Long-Term Goals (More than Ten Years)
The general rule is that the more time you have to reach a financial goal, the more investment risk you can afford to take. For many investors, that can mean allocating most of the principal you set aside for long-term goals to growth investments, such as individual stock, stock mutual funds, and stock exchange traded funds (ETFs).
While past performance is no guarantee of future results, historical returns consistently show that a well-diversified stock portfolio can be the most rewarding over the long term. It’s true that over shorter periods—say less than 10 years—investing heavily in stock can lead to portfolio volatility and even to losses. But when you have 15 years or more to meet your goals, you have a good chance of being able to ride out market downturns and watch short-term losses eventually be offset by future gains.
In addition, some investors successfully build the value of their long-term portfolios buying and selling bonds to take advantage of increases in market value that may result from investor demand. Others diversify into real estate or real estate investment trusts (REITs). The larger your portfolio and the more comfortable you are making investment decisions, the more flexible you can be.
Tax-deferred and Tax-free Accounts
For long-term goals such as retirement or education for your children, you can give your portfolio a significant boost by taking full advantage of any available tax-deferred and tax-free investment accounts.
When you invest through a tax-deferred account, including traditional individual retirement accounts (IRAs) and employer sponsored plans, such as 401(k)s, you don’t owe income tax until you begin making withdrawals from the account, presumably after you retire. Because you don’t have to pay taxes on your earnings every year, your investment compounds untaxed, significantly enhancing its long-term growth potential. In some cases, you can defer taxes on your contributions to these accounts as well, helping your account to compound even faster.
You may reap even greater tax advantages with a tax-free retirement or education account, such as a Roth IRA or Roth 401(k) (if your employer offers this alternative), or a 529 college savings plan or Coverdell education savings account (ESA). As with tax-deferred accounts, you owe no tax on current income or capital gains on realized profits in a tax-free account. In addition, your withdrawals are federally tax-free—and may be exempt from state and local income tax as well, depending on the type of account—provided you follow the rules for withdrawals.
You’ll want to give some thought to the types of investments that are best suited for tax-deferred and tax-free accounts. Growth investments, such as stock and stock funds, benefit from the potential for long-term compounding. The only drawback is that withdrawals from tax-deferred accounts are taxed at your regular tax rate, which is higher than the rate you’d pay on qualified dividend income and capital gains. Bonds also have a place in your tax-deferred and tax-free accounts, as do mutual funds and ETFs that invest in stocks and bonds.
Since most bond interest is taxable at your regular rates, you don’t increase what you owe by holding bonds in tax-deferred accounts. However, investments that are already tax-exempt, such as municipal bonds or municipal bond funds, may not be suitable for tax-deferred accounts and typically are more appropriate for a taxable account or a Roth account. When you hold a tax-exempt investment in either a taxable or tax-free account, you do not have to pay taxes on the interest you earned. But, because of how the tax law works, if you hold a tax-exempt investment in a tax-deferred account, your earnings become taxable when you withdraw them. In some cases, purchasing a tax-exempt investment in a tax-deferred account may be suitable. For example, a tax-exempt municipal bond may offer a higher yield than a similar taxable bond, even taking into consideration the loss of the tax exemption. If your investment professional recommends a tax-exempt instrument for your tax-deferred account, ask how he or she determined that the investment was appropriate for you. In addition, your investment professional must make a disclosure to you regarding the loss of the tax exemption.
Once you’ve devised a strategy for choosing investments appropriate to each of your goals, you’ve taken a major step toward meeting them. But building your portfolio is just the first part of the process. You may also find that as your life circumstances or priorities evolve, or as a major goal approaches, that you need to change the mix of investments in your portfolio. That’s all part of being an investor.
Keeping an Eye on the Big Picture
Setting investment goals and making investment choices is just the beginning. You’ll also want to learn as much as you can about how to evaluate potential investments and keep track of the progress you’re making toward accumulating the money you need to reach your objectives. That doesn’t necessarily require checking your account every day, but it does mean that you should keep an eye on whether the value of your portfolio is increasing from month to month and year to year. It often pays to take a long-term perspective on investing and not be too hasty to switch investments based on short-term results.
But if your investments aren’t delivering the results you had anticipated over a period of time, especially if the financial markets as a whole are doing well, you should be prepared to seek alternatives.
You’ll also want to keep in mind the passage of time. What you initially considered to be long-term goals can become mid-term and short-term goals very quickly. That requires rethinking how your money is invested and whether you should begin to make some changes.
In addition, while some goals are flexible and can be postponed, others have specific dates. For example, many students begin college at 17 or 18, and need money for tuition at that point, not several years in the future. Other goals are more flexible. You can often wait to buy a home or postpone retiring from your job if that extra time will make it more affordable.
Be prepared for surprises. For example, many people retire earlier than they had planned because their employer downsizes or a company closes its doors.
Since your income, monthly expenses, and lifestyle situations are likely to change over time, you should re-evaluate your finances regularly, to be sure your expense and investment plan is still meeting your needs.
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