A Short Guide to the World of Financial Investments. Part Five
Practice Is the Criterion of Truth, the Best Teacher, and the Key to Success: How to Build an Investment Portfolio in Just One Day
What It Is, Why You Should Do It and Where to Start
In the fourth part of this short guide, we formulated the basic principles and rules to follow when building an investment portfolio. In this final part of the guide, we will demonstrate how an individual can practically build his or her investment portfolio by using the financial instruments that are currently available to non-professionals.
In the second part of the guide, we also found out that if there is a reasonable diversification of the investment portfolio, it is possible to reduce the level of risk while maintaining the same level of return on investment. How can this diversification be achieved? This diversification can be achieved by investing in security market indices rather than in securities issued by individual companies or governments.
An index reflects the price performance of a basket of securities that have been selected according to certain criteria. For example, the Dow Jones Industrial Average stock index reflects the price performance of a basket of stocks issued by 30 large (“blue-chip”), publicly traded US companies. The Standard & Poor’s 500 index reflects the price performance of a basket of stocks issued by 500 largest publicly traded US companies. In turn, the Nasdaq Composite stock index, for historical reasons, reflects the price performance of a basket of stocks issued primarily by publicly traded technology companies. There are numerous security market indices comprised of stocks, bonds, real estate investment trusts, commodity funds and alternative investments. They can be selected according to a variety of criteria: by company size, by industry, by geographical region, and so on. We can say that the concept of a security market index is very close to the concept of a “consumer basket” which reflects the preferences of the so-called “average” consumer. Thus, the price performance of any security market index reflects the “average” price performance of securities that have been selected in accordance with some criteria.
How can a non-professional investor buy security market indices? He or she can do this by investing in exchange-traded funds or ETFs. There are numerous ETFs that are currently available to non-professionals. Furthermore, new funds are launched on a regular basis. Each individual fund reflects the value of a particular security market index. And you can buy or sell an ETF in the same way you buy or sell a stock. These funds are created and launched by large banks or asset management companies. Unlike mutual funds, exchange-traded funds are mostly passive investments that track the performance of a particular index or basket of securities. In this way they provide non-professional investors with the opportunity to gain access to various asset classes: stocks, bonds, real estate investment trusts, commodity funds and alternative investments. As a result, it is much easier for any non-professional investor to build a more diversified investment portfolio.
In the fourth part of the guide, we also found out that capital is not just about finance. This implies that the principle of diversification should be applied to other areas of life. The greater the “biological” and “social” capital of an individual, the greater the risk he or she can afford in relation to financial investments.
The most important decision when building an investment portfolio is the allocation of funds by asset classes (see Picture 5.1 below). The percentage of each asset class may vary depending on your time or investment horizon and risk tolerance. The longer your time or investment horizon, the greater the risk you can afford. The greater your “biological” capital (physical and mental health) and your “social” capital (job, education, experience, social connections, family situation), the higher the percentage of riskier asset classes.
In this guide we will focus on the “average” investor whose goal is a moderate portfolio growth in the medium and long term. We will give examples of index-based exchange-traded funds that are currently available for non-professional investors. That is why you just need to check whether these index-based funds are offered by your bank or brokerage firm.
Cash and short-term money market instruments: 5% of the portfolio. The availability of cash will allow you to reduce the volatility of your portfolio, while retaining the ability to exploit interesting investment opportunities during price corrections. Alternatively, cash can be invested in short-term government securities. This can be done by purchasing exchange-traded funds that track the performance of the ICE U.S. Treasury Short Bond Index or the eb.rexx Government Germany 0–1 Year Index.
Alternative investments: 5% of the portfolio. Alternative investments include investments in non-listed stocks or private equity, actively managed hedge funds, currencies and cryptoassets. To get exposure to this asset class you can purchase exchange-traded funds that track the S&P Listed Private Equity Index, the db Hedge Fund Index, the db Short USD Currency Portfolio Index, and the MVIS Global Digital Assets Equity Index.
Commodities: 5% of the portfolio. Precious metals are also included in this portfolio. By purchasing an exchange-traded fund pegged to the Bloomberg Commodity Total Return Index, you will get exposure to commodities, including precious metals.
Real estate investment funds: 10% of the portfolio. By purchasing an exchange traded fund that tracks the Dow Jones Global Select Real Estate Securities Index, you will get exposure to real estate investment trusts or REITs and real estate operating companies or REOCs. These trusts and companies directly own and manage commercial and residential real estate as well as infrastructure.
Now we should allocate the remaining 75% of the portfolio between the two major classes of financial investments: stocks and bonds. In the second part of this guide, we found out that stocks are instruments with a greater potential return on invested capital and a greater potential risk. That is why you can afford a higher proportion of investments in stocks if you have a higher level of financial, biological, and social capital.
To simplify our task, we can assume that our age is the starting point for determining our investment horizon. Next, given our attitude towards risk, we can describe our risk tolerance as either conservative or moderate, or aggressive. Based on this risk tolerance assessment, at the first stage we can calculate the percentage of stocks in our investment portfolio according to a simple formula (see Picture 5.2 below).
At the second stage, we can adjust the percentage of stocks by considering our biological capital (physical and mental health) and social capital (job, education, experience, social connections, family situation). If we assess our biological and social capital as “average”, the percentage of stocks calculated at the first stage does not need to be adjusted. If we assess both capitals to be above average, we can increase the percentage of stocks by 5 percentage points for each capital.
For example, if your risk tolerance is average, if you are 35 years old and in good health (high biological capital), if you are well educated and well employed (high social capital), then the percentage of stocks in your investment portfolio is calculated according to the formula: (110%-35%+5%+5%) * 0.75 = 64%.
In the fourth part, we found out that when building your investment portfolio, you can adhere to the simple principle of 60/30/10. 60% of investments should form the “core” of the portfolio consisting of assets whose value reflects the current structure of the economy. 30% of the portfolio may consist of securities issued by companies that are associated with “promising” industries with the prospect of becoming the “backbone” of the economy in the not-so-distant future. 10% can be invested in speculative assets: “cheap” shares of problematic companies, shares of companies whose products one is very passionate about, trendy and fashionable stocks. We can apply these principles when building both our bond portfolio and our stock portfolio (see Picture 5.3 below).
Bonds. 60% of the bond portfolio can be invested in investment-grade debt securities. For example, you can purchase an exchange-traded fund that is pegged to the Bloomberg Global Aggregate Bond Index. 30% can be invested in a high-yield liquid exchange-traded fund that tracks the Markit iBoxx Global Developed Markets Liquid High Yield Capped Index. 10% can be invested in either high-yield, speculative-grade or convertible bonds at your discretion. There are exchange-traded funds that track the ICE BofAML Diversified High Yield US Emerging Markets Corporate Plus Index, the Bloomberg Global Corporate ex EM Fallen Angels 3% Issuer Capped Index, the Refinitiv Qualified Global Convertible Index, the Iboxx Content Convertible Liquid Developed Europe AT1 Index and similar high-yield, speculative-grade or convertible bond indices.
Stocks. 60% of the stock portfolio can be invested in an MSCI ASWI Index-pegged exchange- traded fund. The funds that are pegged to this index include stocks from both developed and emerging markets. 30% of the stock portfolio can be invested in five to ten ETFs that track thematic indices. Thematic indices represent baskets of stocks of companies from the so-called promising industries, fields or regions: high and breakthrough technologies, biotechnology, automation and robotics, digitalization, video games and e-sports, artificial intelligence, healthcare innovations, electric vehicles and autonomous cars, batteries for electric vehicles, clean energy, cybersecurity, smart factories, cloud computing and big data, blockchain, fintech, population aging, developing countries from various regions, emerging markets consumers and others (see Picture 5.4 below). Banks and asset managers regularly launch numerous thematic funds focusing on new industries, fields, and geographical regions. 10% of the stock portfolio can be invested in a speculative subportfolio at your discretion, including the purchase of individual stocks, derivative-based or leveraged exchange-traded funds or special purpose acquisition companies (SPACs).
The percentages for each asset class can be adjusted, if there are changes in your life circumstances. If your health has deteriorated, then the assessment of your biological capital should be downgraded. This implies that you should lower the percentage of stocks in your investment portfolio since stocks are usually associated with a higher level of risk. If you are experiencing job-related distress or family problems, then your social capital is also declining. In this situation it would be prudent to lower the percentages of riskier asset classes. On the contrary, if you managed to move up the corporate ladder, then you can afford to increase the percentage of riskier assets in your portfolio.
The percentages of asset classes can also be adjusted due to changes in external factors. If you think that interest rates will rise in the foreseeable future, you can increase the percentage of money market funds that invest in short-term debt instruments.
If you already have large real estate investments, you can lower the percentage of portfolio assets held in real estate investment funds. If you are extremely conservative, you can increase the percentage of assets invested in precious metals, particularly, in gold. If you avoid speculation altogether, you can redirect the funds earmarked for the sole purpose of speculation towards thematic equity ETFs. Constantly monitor new thematic equity ETF launches since these funds will provide you with the opportunity to invest in promising industries, fields, and geographical regions.
And most importantly: act now! Only practice is the criterion of truth, the best teacher, and the key to success!
