6 stages of investment portfolio formation:
One of the main mistakes of most investors (especially beginners) is the wrong approach to portfolio formation.
Without a doubt, there is no problem in choosing a specific investment product. For example, you might say “I want to buy an ETF on the S&P 500”. The problem arises when you try to invest all your capital wisely.
One of the main points that an investor must realize is the fact that choosing a single product is only the last step.
But how many times have different investment managers or advisors made the same mistake? How often in response to the question “where can I invest my 50,000 euros?” Do they recommend a specific product first?
1. The right approach
In today’s article, we will look at steps that will help you avoid the error. Here is what the investment decision tree looks like:
Analysis of current income and available assets;
Definition of financial goals;
- Determination of the time horizon of investment;
- Determining the strategic direction of investment;
- Definition of the tactical structure of the portfolio;
Selection of individual products.
Following this logical chain, the investor will be able to build a portfolio that meets his needs and goals. As you can see, choosing a product is just the last step.
2. Analysis of current income and available assets
If you have 50,000 euros of investment capital, but every month you earn 1000 euros and spend 1200 euros, then you have a problem.
It is impossible to invest all the capital without creating a sufficient stock of liquidity to meet short-term needs. Therefore, it is important to answer the question: do I know how much I earn and spend every month?
By answering this question, the investor can determine his savings rate and plan for further liquidity inflows to build capital.
In terms of financial position, you, like any company, will have to assess the ratio of debt to your total assets.
This is important in terms of understanding the starting point and the reality of investment goals. For example, it is impossible to make 1,000,000 euros from a starting 50,000 in just five years (I’m talking about investments, not about playing in a casino).
3.Investment goals
Having dealt with the initial data, we move on to the next point: “what do you want to achieve with your money?”.
This question goes hand in hand with the definition of the investment horizon. For example, you want to buy a house in 5 years, get married in 10 years, send your kids to a good university in 18 years, or guarantee a decent retirement in 40 years.
The combination of real numbers and timelines allows you to define a clear goal that will help you allocate capital and not go astray during periods of increased market volatility.
4. Definition of the portfolio structure
Only after going through the previous steps can we focus on real portfolio building (which also contains many pitfalls).
The structure of the portfolio should be consistent with its objectives. You cannot invest everything in stocks if the horizon is only 2–3 years. This is because the volatility of the stock market in the short term can be so high that in 3 years you will be in the red.
Similarly, it is best not to invest in short-term foreign exchange instruments or bonds if you are preparing to retire in 35–40 years, as this will freeze your capital and you will miss out on many promising opportunities.
Portfolio allocation is divided into two stages:
strategic
tactical
The first step is to determine what percentage of capital will go into stocks, commodities, bonds, and other assets.
The second stage involves the distribution of capital within individual asset classes. For example, if you invested 50% of your funds in the stock market, then you need to determine the shares of emerging markets, European assets, individual sectors, etc.
Thus, before asking the question “where do you invest your 50,000 euros”, there is a lot of work to be done, otherwise it all makes no sense.
5.Summarize
“Investing is simple, but not easy,” Warren Buffett once said. The list of necessary steps looks simple, but in practice, their implementation requires perseverance, discipline and humility.
At the same time, the strategy should also include periodic balancing of the portfolio, adjusted for significant events.
