The collection of financial assets you invest in, which may include stocks, bonds, cash, and alternative investments, is your portfolio. A helpful way to think of your portfolio is as a pie divided into slices of different sizes, with each slice representing a different asset class. Your portfolio may be composed of 50% stocks, 30% bonds, 10% private equity, and 10% real estate, or it might be composed of 80% stocks and 20% bonds with 0% allocated to alternatives. Each asset in your portfolio is associated with a risk level – the probability that you will lose your capital by investing in that asset – and a rate of return. The ideal portfolio for you maximizes your returns given your risk tolerance.
When building your portfolio, you need to take into account two key parameters: your risk tolerance (how much risk you’re willing to take) and your time horizon (how long you’d like to stay invested for). These two parameters will help determine how you should allocate your money among different asset types. For instance, if your risk tolerance is high and you’re willing to stay invested for a long while, you may go for riskier stocks and alternative investments.
However, if your risk tolerance is low and you need to sell your assets soon to buy a house or pay your children’s college tuition, you will go for assets with less volatility and more predictable returns, such as bonds or dividend-paying stocks of established companies.
Building a diversified portfolio allows you to manage risk. You can achieve diversification by investing in asset classes that are not correlated with one another (because they are driven by different factors). That way, while a part of your portfolio may fall, the remainder may remain unaffected. You can also achieve a degree of diversification by investing in different categories within a certain asset class – for instance investing in both office and multifamily real estate or stock of both established, dividend-paying companies and younger, growth-oriented companies.
Over time, the price of some assets in your portfolio may rise and that of others may fall, changing the size of the pieces of your pie and disrupting the proportions of your portfolio. Rebalancing is how you restore your investment portfolio to its original makeup – you sell assets that have increased in price and buy assets that have decreased in price to return to your target asset allocation and maintain a portfolio that suits your risk tolerance.