Investment Portfolio : Components, Types, Risks & Advantages

What is Investment Portfolio?

An Investment Portfolio (or financial portfolio) is a combination of financial assets an investor owns, including stocks, bonds, money market instruments, cash and cash equivalents, and other financial or non-financial assets. Further, a portfolio investment refers to the group of investments formed in the expectation of earning a return or the value growing with time. This differs from direct investment which includes an active management role, whereas portfolio investment involves passive or indirect ownership of assets or management roles. Investors here look for significant returns supporting their financial goals and risk appetite.

Geeky Takeaways:

• An investment portfolio is a financial asset that is bought with the expectation of earning a return or the value growing with time.
• Mainly two categories namely Strategic investment (long-term approach) and Tactical investment (short-term approach).
• Risk tolerance and time horizon are the two key factors in choosing an investment portfolio.
• The investment portfolio comprises a broad range of financial assets such as stocks, bonds (corporate and government), real estate investment trusts (REITs), mutual funds, exchange-traded funds (ETFs), and bank certificates of deposits (CDs). Options, futures, and warrants are also included in the portfolio investment.
• Investors create a portfolio to generate revenue while maintaining the capital or share of the asset preserved.

Components of a Portfolio

Different types of asset classes comprising various securities combine to form the components of an investment portfolio. The investors must make sure that their portfolio consists of a good combination of assets that has the potential for capital growth with limited or controlled risk. The following lists the components of an investment portfolio.

1. Stocks or Equity: One of the most common components of an investment portfolio is the Stocks, which refers to the shares of the company and ownership of investors in the company. Stocks are the depiction of the overall share capital of a particular company traded over the stock exchanges. The portion of ownership owned by an individual is determined by the number of shares held by the individual. The individual is known as the shareholder or stockholder, who has accredited a portion of the company’s profits in the form of dividends. Investors can generate higher returns by selling the stock they hold at a higher rate in the stock market with a potential risk factor. Hence, stocks are known to be a reward-generating component of an investment portfolio.

2. Bonds: Another component of an investment portfolio is the bonds, which are investment securities where investors lend money to the government or a corporation for a specified period with the condition of receiving regular interest payments. Bonds have a predefined maturity date, after which the principal amount is returned to the investor along with the interest amount. Compared to stocks, bonds are a little less risky and thus offer low returns. Hence, bonds are known to be the risk-protecting component of an investment portfolio.

3. Alternative Investment Options: An investment portfolio might consist of other forms of investment such as oil, real estate, gold, commodities, etc. These are assets that grow in value and multiply with time. These alternative investment options are not commonly traded compared to the traditional investment options of bonds and stocks.

Types of Portfolios

Investment portfolios are of different types and investors believe in creating a portfolio that would fulfill their investment objective and risk appetite.

1. Growth Portfolio: The prime objective of this portfolio is to foster growth by considering the potential risks and investing in the companies that are growing. Higher returns and higher risk are part and parcel of the growth portfolios. Usually, investments in younger companies have the potential for higher growth compared to those already established big corporations.

2. Income Portfolio: An income portfolio’s prime goal is to maintain a continuous flow of income from the different investment options instead of focusing on potential capital growth. For example, income-minded investors would rather invest in stocks that reap regular dividends, than the trend of growth in value. Further, fixed-income assets generally offer regular income to investors, thus investors looking for steady returns can invest in this form of portfolio.

3. Value Portfolio: In a value portfolio, investors purchase cheap assets due to their low valuations and look for opportunities to generate profits in the investment market. During economic turmoil, when companies and markets struggle to survive, these portfolios are used by value-oriented investors as they can invest in those shares of companies whose prices have lowered compared to the fair value. Again when the market revives, investors in these portfolios can generate higher profits by selling their investments.

Investment Portfolios and Risk Tolerance

Risk is the degree of uncertainty or potential downs in the financial market due to the poor performance of an asset class or the market as a whole. The risk tolerance or risk appetite of investors is basically how much the investor is willing to invest and how long can the investor tolerate depending on the volatility of the market. This risk tolerance affects the allocation of funds and financial assets into the investors’ investment portfolio.

There are three types of investor risk tolerance levels, low-risk, moderate-risk, and high-risk. Multiple factors such as nature of income, number of dependents, liquidity requirements, etc have to be considered before deciding in which level a particular investor falls.

Suppose, an investor wants to generate revenue in a short period and avoid the volatility of the market, then this is a level of low risk. This type of conservative investor often builds a portfolio comprising large-cap value stocks, investment bonds, cash equivalents, market index funds, etc.

Whereas, if the investor wants to invest for a longer period, (say more than 15-20 years), and has a higher capacity to hold more market volatility and ups and downs, then it is a case of high-risk tolerance. Here, investors with high-risk appetites focus on investing in the investment portfolio comprising small-cap and large-cap growth stock, high-yield bonds, oil, gold, real estate, etc.

Thus, before investing, you should always understand your risk appetite so that investment doesn’t bring financial stress to your life. The portfolios should be designed in such as way that your risk appetite is properly covered.

Steps of Building an Investment Portfolio

There exists a process of building an investment portfolio. The following steps show how an investment portfolio be built.

1. Initial Preparation: Find out your present financial condition. Here, you have to list down your assets (stocks, mutual funds, cash, property, bonds, etc.) and your liabilities (debts, credit card dues, education loans debt, home loans debt, etc.). This will form a balance sheet that will give a better picture of your financial status and will help in deciding your financials for your future.

2. Credit Card Debts: As early as possible, the credit card debts should be paid off. These steps would ensure you are clear from any debt related to credit cards,

• List out your debts and rank them based on their interest rates in high to low sequence.
• Estimate the funds required from your monthly income to pay off your debts.
• Give the highest priority to the card having the highest interest rate pay off the debt and pay the minimum balance of all other credit card debts.
• Continue repaying all the debts from your account.

The elimination of debt from your account might take a few months or even years. Try to avoid additional charges and make different attempts to earn extra income and pay off your debts as soon as possible.

3. Purchase a House (An Asset): In this step, save your earnings for purchasing a house via a down payment. The main motive is to convert your rent liability into an asset by being the owner of a house. As per the Income Tax Act, of 1961, the principal amount and interest amount are both exempted from tax rules.

4. Create an Emergency Fund: A minimum of 6 months’ living expenses must be created to cover any unavoidable circumstances such as unemployment, sudden home renovations, medical emergencies, etc. Some of the investment options to create emergency funds are overnight funds, liquid mutual funds, savings accounts, money market instruments, etc. The prime goal of an emergency fund is safety and liquidity rather than returns.

5. Hunt for Other Investment Options: After these initial 4 steps, look for investment options like bonds, stocks, ETFs, mutual funds, CDs, etc. You are allowed to hire a financial advisor who is an expert in building a portfolio that would boost your investment journey.

6. Invest in Yourself: To stand out in the crowd, one has to invest in themselves by undertaking valuable educational courses. Either by improving professional skills or starting your own business, you need to have the basic idea and process to fulfill these objectives. This will help you to shine among other employees and increase your earning capacity and then you can elevate your financial plans.

7. Save for Education: It is the dream of every parent to provide the best possible life for their children. Thus, educating them in the best possible way is a solution and as with time, the expenses in the education sector are increasing drastically, so it is necessary to plan for the financials or build the educational corpus beforehand.

8. Stay on Course: By following the above steps, you are in a better position financially. The road to success is by making informed decisions and abiding by your created plan. Wealth creation relies on continuous and regular effort that counts.

Importance of a diversified portfolio

The importance of a diversified portfolio is listed below,

1. Volatility: A diversified portfolio has the capacity to reduce the risk factor associated with each asset class invested in the market.

2. Benefits of Different Investment Options: Different investment options namely mutual funds, exchange-traded funds, fixed deposits, etc can help investors to take benefit of the different features of each instrument and reduce risk. Suppose, you invest in fixed deposits, you can receive fixed interest at lower risk. If you invest in mutual funds, you have the potential to earn higher returns with equal higher risk.

3. Preservation of Capital: Investors seek to preserve their funds either by taking risks or by preferring stability. Portfolio diversification is able to help investors in fulfilling their desires. Investors are able to achieve their desired financial goals because of diversification which limits the risk of individual investment.

4. Management of Risk: With a diversified portfolio, an investor is able to generate weighted average returns for the underlying securities on which investments were made. Thus, they won’t be fully exposed to the market volatility and also the risk associated with a single security.

5. Peace to Investors: Among all the advantages, one of the best advantages is that a diversified portfolio provides a peaceful life to the investors. When the total capital is distributed among different assets, an investor will be chilled out with taking stress about the performance of the portfolio.

Advantages of Portfolio Investment

1. Mitigation of Risk: The prime objective of building a portfolio is to reduce risk while averaging the returns from each asset. In other words, the portfolio offers robust resistance toward unavoidable risk while generating steady returns.

2. Diversification: A well-designed investment portfolio is made up of numerous asset types that are unconnected to one another or have a negative correlation with one another. For instance, a small amount of gold in a portfolio rich in equities might be a good way to reduce risk. Portfolio diversification is important since it makes overcoming volatility easier.

3. Systematic Approach: One of the best practices of the investment portfolio is that a systematic approach is followed throughout the time of investment. Such that if an investor is interested in value-based investment, then that individual should not invest in growing companies to avoid the related outcomes. Thus, an investment portfolio is built to track the risk factors and the performance of the assets invested.

4. Resistance Towards External Crisis: In an investment portfolio, asset classes are carefully included considering different weights to ensure the best possible returns for the investor. In this manner, the assets can overcome external crises and stand throughout.

Disadvantages of Portfolio Investment

1. Higher Transaction Cost: The frequent buying and selling of assets in the market within the portfolio can sometimes incur transaction costs such as brokerage fees, commissions, and charges for trading in the exchange market. This might decrease your return value and reduce the profit on the portfolio.

2. Market Downfall: As the market is volatile, even a well-diversified portfolio might face repercussions. During the economic crisis, the price of certain investments might fall tremendously ultimately reducing the value of the portfolio. Thus, although diversification reduces risk, it cannot completely wipe off the adversities of the market.

3. Over-Diversification: When excessive types of investments form the portfolio, then over-diversification occurs. As it is said, too much of anything is bad, the same goes for the case of an investment portfolio. A diverse range of securities can limit the potential profits. Over-diversification instead of boosting protection, might happen to reduce the overall performance of the portfolio by making it difficult for the high-performing investments to improve their returns. Thus, in an investment portfolio, over-diversification should be avoided to maximize profit.

Frequently Asked Questions (FAQs)

1. What does an ideal investment portfolio look like?

Answer:

An ideal investment portfolio offers the optimum potential gains while considering the investor’s risk appetite. Suppose, an investor has a medium risk appetite, then the portfolio should contain a balance of blue-chip stocks and debt securities for maximum impact.

2. Why is an investment portfolio required?

Answer:

As the future performance of the assets and the market is unseen, it is thus advisable to spread our funds into diverse asset classes to protect our fund while ensuring steady growth even during crisis situations.

3. What is a stock portfolio?

Answer:

A stock portfolio comprise of equity stocks. Around 20 – 30 companies’ stocks can form the portfolio generating a good potential returns. The combination of companies depends upon the risk profile and growth expectations of the investor.

4. Can the risk factor increase if one opts for portfolio investment?

Answer:

In most cases, the instruments chosen for a portfolio are to help reduce the risk quotient to the minimum. So it is unlikely that your risk factor will increase if you build a portfolio.