Investing 101: How To Build An Efficient and Effective Portfolio
Welcome to our First Dakota Wealth and Trust Investing series, where we'll dive into the core elements that can help your investment plan shine.
Today, we’ll focus on constructing a healthy portfolio.
Building an effective portfolio customized to your needs is an essential part of reaching your unique goals.
But there are so many moving pieces that bring everything together. Let’s explore!
Start With Your Investment Goals
The thing with investing is that every person, and the goals they’re working towards, is different.
A college graduate will likely have wildly different goals than a 42-year-old father of three teenagers. Whether you’re just getting your feet wet with investing or looking to optimize your portfolio further, the first step is to ascertain your goals.
Ask yourself a few questions:
- Why are you investing?
- What do you want to accomplish?
- Why is this goal important to you?
- How can it further your life?
Once you discover your unique “why,” you and your financial team can start refining your plan. Now, you’ll be able to dive into even more specific questions about what your goals aim to achieve.
- When will you need the income?
- Who benefits from your investment? Yourself, kids, grandkids, etc.?
- Are your investments part of a larger estate and legacy plan?
Starting with your goals provides a rich foundation for the rest of your investment plan and informs the type of vehicles you can use to invest. If, for example, you have a goal of funding your grandchild’s education, but you also want them to be able to use the money for other expenses, you might consider a Roth IRA, a custodial account, and/or a 529.
Understand Your Risk Tolerance
Your risk tolerance plays an important role in your long-term investment practices. Let’s take a closer look.
Your risk tolerance is the combination of two distinct elements:
- The amount of time you have to invest before reaching your goal (such as saving for retirement), and
- How drastic a change in your investment value you are willing to accept.
Bringing back our college graduate, she has a great deal of time before retirement, but she’s troubled by the thought of her investments losing significant value. Her risk tolerance would be moderately conservative.
However, our father of three may not have as many years to invest before retirement, but he may also want to see as much growth as possible in a shorter timeframe. In this case, his risk tolerance would be higher and more aggressive.
Think about this: How would you feel if your investment lost 15% in a matter of weeks? Could you handle that risk for the potential of a 15%+ rebound within the same period?
Asking questions like this can help suss out what level of risk you’re willing to take. There is no right or wrong answer regarding your risk tolerance, and the answer will likely change as you move through life and reach certain milestones. Yours depends on your propensity for risk and how taking (or not) fits in with your goals.
Nail Down Your Time Horizon
Earlier, we spoke a bit about determining how much time you have for your investments to grow before you need them. This term is known as your time horizon.
Your time horizon draws a straight line through your risk tolerance and your goals. Sound familiar? Each of these elements works together to help you connect all the dots.
How can you determine your time horizon?
First, understand your goals, then decide how quickly you want to achieve them.
A savings goal like retirement offers many investors a longer time horizon because they start investing early on in their careers and plan to work for several decades before touching the funds.
A goal like education funding, for example, may come with a shorter time horizon—roughly 18 or so years. Other goals like funding a downpayment for a vacation home or house remodel may even have a shorter time-clock.
Setting your time horizon comes from understanding your goals and can influence the type of securities you invest in. More on this below!
Build Your Asset Allocation
After you have thought about your goals, your timeline, and your tolerance, what happens next?
You get to start building your portfolio!
Start by thinking through the type of investments available: stocks, bonds, mutual funds, ETFs, real estate investment trusts (REITs), private equity, etc. In all likelihood, your portfolio will combine a few types of assets most appropriate for you.
What do these asset classes look like? Let’s define some key terms.
- Stocks. A slice of ownership in a company. If you buy 10 shares of Apple, you’re now a part-owner of Apple. The hope is for the individual stock values to rise with time, but the risk is that they will lose value.
- Bonds. Bonds are a type of fixed-income investment and are loans to companies or governments that get paid back over time with interest. In general, bonds are often considered “safer” or less risky than stocks. The trade-off, then, is that bonds tend to have much lower rates of return. Bonds are a great balancing agent in your portfolio.
- Mutual Funds. Mutual funds are a collection or basket of several securities usually comprised of both stocks and bonds. Investing in a mutual fund opens up your investments to a broader range of companies. Instead of buying one share of Apple stock, one mutual fund share may open you up to dozens of companies, making it ripe for diversification. Most mutual funds are actively managed and can come with higher investment fees.
- Index Funds and ETFs. Both of these investments seek to match or out-perform a particular index, like the S&P 500. Since you invest in similar assets to the index, most don’t require an active fund manager, making them a low-cost vehicle.
What does this have to do with building your portfolio?
Depending on your risk tolerance and investment goals, you can choose what percentage of equities (stocks, mutual funds, ETFs) and fixed income (bonds and bond funds) you want to include in your portfolio.
For someone with a higher risk tolerance, that can be up to 100% equities and zero bonds. Someone looking to be a bit more balanced may opt for a 60/40 or even 50/50 split. It all depends on what you’re looking for. Those interested in growth tend to focus more energy on equities, whereas someone looking to generate income may gravitate towards bonds.
Up until this point, you’ve accomplished quite a bit: nailed down your goals, discovered your risk tolerance, set your time horizon, and decided on your asset allocation.
You’re set, right? Not quite.
The next step is to diversify your portfolio within each asset class. What does this mean? Diversification is a strategy to balance risk and return by investing in various asset classes that respond differently to market conditions.
By diversifying, one investment doesn’t comprise too significant an influence over your portfolio’s value. Think about it like the government’s checks and balances system. Checks and balances help ensure that one branch isn’t too powerful and can’t control the entire picture; the same is true for your investments.
Say one stock had a terrible year. Without proper diversification, your portfolio’s value could feel the hit significantly. By diversifying, one underperforming asset won’t make or break your returns.
Diversification comprises several factors; some of the ones we focus on at First Dakota are industry (technology, communications, agriculture, etc.), company size (small, large), and location (domestic or international), to name a few.
Think about diversification, like having tiny slices of a lot of pies. If you went to a pie contest (yum), you’d likely want to try as many small pieces as possible instead of filling up on just one or two.
Investing this way allows for a lower overall risk than taking a large chunk of a single pie.
Don't Forget About Taxes
Now your portfolio is all diversified and ready to start generating returns. But there’s still another element to consider along the way: taxes.
How your investments impact your taxes is ongoing and changes year to year depending on your realized and unrealized gains and other income opportunities.
How can you invest tax efficiently? Ensure your portfolio is balanced between both taxable and tax-free investments via a strategy called asset location.
Asset location is all about housing investments in the most tax-friendly accounts. While this is not always possible, it is something to look at before purchasing an investment. Asset location won’t outweigh proper asset allocation, but it is another factor to consider.
Our Wealth & Trust Team Would Love To Help You Build A Strong Portfolio
As you can see, creating a portfolio that’s built to help you achieve your goals is no small feat. There is a lot of time, energy, and strategy that goes into creating, monitoring, and updating your investments, so they continually reflect your unique investment situation.
Remember, every element of your portfolio—goals, risk tolerance, time horizon, asset allocation, diversification, and tax planning—works together to help you achieve your goals.
Whether you are a novice or a seasoned investor, the First Dakota Wealth & Trust team is here to help you navigate the investment world.
We love working with people to help them invest in intentional ways completely designed to support their vision for life. If you’re ready for an investment refresh, set up a time to talk with our team. We’d love to answer your questions and get you on the right path.
First Dakota Wealth & Trust is the fiduciary investment department of First Dakota National Bank with trustee powers to serve clients during their lifetime, during incapacity, and after death. We help clients develop a financial roadmap to help simplify their financial future.
Please note that neither First Dakota National Bank nor First Dakota Wealth & Trust Department, or its employees provide tax or legal advice. This is intended for informational purposes and is not intended to constitute legal or tax advice. Please consult your attorney and/or tax professional for advice related to your specific situation.