Why construct investment portfolios?
When we talk about investing in the stock market, we usually talk about investment portfolios of publicly traded assets such as bonds, stocks, or traded funds. Even when recommending individual stocks or bonds, most stock analysts talk about them as “additions” to your existing portfolios and not individual investments.
Similarly, when we talk about specific ETFs or stocks, we consider them part of a broader portfolio of holdings. Why is that?
The biggest reason is the diversification of your investments. In the simplest terms, we don’t want to invest all of our money in one stock. If the value of that stock declines or the company goes bankrupt, we can lose everything. So to spread the risk, we buy a few more stocks or bonds.
Claims against diversification
People will claim that diversification is for people who don’t know what they are doing. Warren Buffet once said that you could not love your number one stock as much as number ten. There is some truth to that. One investment will always be better than others and logically, why not move more money towards that investment? Not many people, even the most trained and “qualified,” can identify better investments with certainty. Almost no fund manager can beat the market over the long term, and who is to say that we can do any better. We believe it can be extremely foolish and dangerous to believe that. The ego is the enemy when it comes to investing. But what about people who put all their money into Tesla or Bitcoin and are now multimillionaires?
Counterargument, in this case, is pretty simple to make. What about people that put all of their money into [Insert any failed company here] and now have nothing. These aren’t glamourous cases that get talked about on social media or the news. That is why investment portfolios will always be a smarter decision than individual stock.
Always consider an alternative case when something goes the other way. The actual outcome is pointless to consider because it is only known after the fact. During your decision-making, known information must be weighed to make an informed decision at that time.
Portfolios achieve specific goals
Every investment should have a clear goal in mind. Wait, isn’t the primary goal of investing to make money? Yes, but there are many ways that investments can pay us.
Stocks with no dividends – When you purchase a share of a company that does not pay a dividend, the only way that investment will produce a positive return is when the stock price increases. That means the value of the company increases. Eventually, when you sell that stock at a higher price, you make money. All of this results in something known as capital appreciation.
Stocks with dividends – When you purchase stocks that also pay dividends, it provides you with an extra income source. Every so often, the company will distribute its earnings to investors holding the stock. Besides, if the stock price increases, you can also sell it for a profit. In combination with dividends, this gives you two possible ways of making money from dividend stocks.
Bonds – similar to dividend stocks, the goal of bonds is to provide you with stable income. Bonds can go up and down in value depending on the market’s interest rate developments, but that is not their primary purpose. Their principal objective is to provide stable fixed income.
Capital preservation – Simply put, you want some returns but don’t want to lose money and preserve your capital. In other words, you want to beat inflation but not necessarily risk your money by investing it aggressively.
Capital appreciation – you want to grow your investments.
Income – you want a stable income from your investments.
Balanced Goals – you want a bit of everything.
Your goals will depend widely on when you want to withdraw your money and the main reason for investing in the first place. Are you saving for a special occasion that is exactly two years from now or retirement that is 30 years from now?
Individual stocks or bonds cannot offer a well-diversified investment for you that will achieve your specific goals. That is why we construct portfolios with goals and risk preferences in mind.
If you are unsure where to start on your investing journey and unsure how to construct your ideal portfolio, check out our investment guide.