A portfolio is the combination of the things you invest in.
Professional investors tend to think a lot in those “combinations” which is known as “Portfolio” and how much is invested in any single part of it, which is called “weight.”
So let’s take for example something easy to understand, stocks.
If we have $10,000 usd and we decide to invest $5,000 into Apple stock, and $5,000 into Netflix stock.
Then our Portfolio of investments would read something like this:
Investment Portfolio
Stocks – $10,000 usd (100%)
Apple- $5,000 usd (50%)
Netflix- $5,000 usd (50%)
Easy, right?
What is the purpose of an Investment Portfolio?
The main reason of creating an investment portfolio is to create diversification, it allows you to reduce your risk by “not putting all of your eggs in one basket”.
Now the “weighting” in your portfolio also depends on your risk tolerance, and personal strategy. Maybe you don’t like to have all your money in just two stocks, so you decide to better spread the risk into 10 stocks.
Would look like this:
Investment Portfolio
Stocks – $10,000 usd (100%)
Apple- $2,000 usd (20%)
Home Depot – $2,000 usd (20%)
Starbucks – $2,000 usd (20%)
Tesla – $2,000 usd (20%)
American Express – $2,000 usd (20%)
In this different portfolio strategy, the weighting was reduced to 20% to each stock but the number of the stocks increased. Remember the weightings can also vary.
If for example you are “sure” (ha-ha) Apple stock will perform better, then maybe you could increase its weighting to 40% and then adjust the rest of the weightings accordingly.
Portfolio Strategy
Now sounds great and everything but let’s do a deep dive into why you need to think in terms of “Portfolios” like the professionals do.
Ok so, you got the basic idea. Portfolio creation = Diversification of risk.
Thats it, right?
Well kind of, people normally tend to get fixated over choosing the “right” stocks, the “right” start-up, the “right” cryptocurrency.
They think they need to over optimize in choosing the “right” one. To some extent, yes, it’s true, you should do your due diligence about what you are investing in and why.
BUT, the other very important component is the assets you are investing in, so for example let’s say you decide to follow the old and boring 60/40 Portfolio.
This is a portfolio that stands for 60% stocks, 40% bonds.
You see the 60% percent component of it you then go on and choose the stocks you want and the weighting that you choose, but in here it’s a whole different game, because you are already incorporating a whole new asset class, which is bonds.
Let’s understand why creating a portfolio with different assets is key.
How the Pros think
Don’t take my word for it.
For instance, Ray Dalio the founder of Bridgewater Associates one of the biggest and most successful hedge funds, with over 200+ Billion AUM (Assets Under Management) said:
“You should have a strategic asset allocation mix that assumes that you don’t know what the future is going to hold.” — Ray Dalio
He once mentioned that the Holy grail of investing was diversification. Ideally you want assets that have different correlations between each other. Why?
If assets have different correlations between each other will allow you to have more “stable” returns by “rebalancing” your portfolio.
How does that process look like?
Let’s continue with the boring but easy, 60/40 Portfolio.
Now let’s suppose the markets come crashing down and your stocks are down -50%. Your weightings now will not be the same as the 60% of your stock portion suffered a cut.
Then to “rebalance” it you would go on to sell part of your bonds that are now more than 40% not because you bought more bonds, but because the value of your stocks went down, and then with that buy more stocks to get them to be again 60 %.
Now that is a simple process with just “2 asset classes -Stocks and Bonds-”
Ray goes on and continues to argue that if you add another asset class you diminish your risk of losing money on any given year even more.
If you do that again with another asset class (ideally uncorrelated) then again, the volatility (risk) diminishes, without sacrificing returns.
If you think about it, starts to look like chemistry, where you would experiment with different substances to achieve the desired outcome, now you can create something completely different.
For example:
Investment Portfolio
Gold 20%
Stocks 25%
REITs 25%
Cash/Bonds 30%
As you can now notice, this portfolio is different in the asset classes that it holds, ideally it would provide a more stable return than let’s say a portfolio consisting of 100% stocks.
Why?
Well for instance if stocks fall by -50% in any given year, probably the Gold, or REITs portion of your portfolio would do better, allowing you to rebalance.
Different kinds of Investment Portfolios
Understanding now this, you can start studying more famous portfolios, developed by the most interesting and brilliant minds of the finance game.
Each of the portfolios is created with a specific goal, so you should understand that, and allocate properly then according to your own needs, risk tolerance, goals, etc.
There are a lot of different portfolios, but here are some that give me lots of food for thought:
· All Weather Portfolio– Ray Dalio
· Dragons Portfolio– Chris Cole
· Golden Butterfly – Tyler (Portfolio Charts)
· Index fund Portfolio– Warren Buffet
· Bitcoin Portfolio– Stackhodler
They really differ, for example the Dragons portfolio, introduces the idea of Volatility as an asset class which is amazing.
The Golden Butterfly show you how Gold in a portfolio can be really key to increasing returns and diminishing risk.
The Index and Bitcoin, though apparently very different in nature, showcase how being “overweight” into an asset, can also be a strategy.
Anyways you can dive deeper if you are interested in any of those, they are vastly different from each other, but the point is to learn and adapt what works best for you.
Remember to always think in terms of different asset classes and diversify, as that is the only “free lunch” on the investing game.
The Ultimate Investment Portfolio is the one that after deep and careful study, lets you sleep well at night.
Until next time.
Zifush.