What is a 'Portfolio'
A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, as well as their funds counterparts, including mutual, exchange-traded and closed funds. Portfolios are held directly by investors and/or managed by financial professionals. Prudence suggests that investors should construct an investment portfolio in accordance with risk tolerance and investing objectives.
BREAKING DOWN 'Portfolio'An investment portfolio can be thought of as a pie that is divided into pieces of varying sizes, representing a variety of asset classes and/or types of investments to accomplish an appropriate risk-return portfolio allocation. Many different types of securities can be used to build a diversified portfolio, but stocks, bonds and cash are generally considered a portfolio's core building blocks. Other potential asset classes include, but aren't limited to, real estate, gold and currency.
Impact of Risk Tolerance on Portfolio Allocations
While a financial advisor can develop a generic portfolio model for an individual, an investor's risk tolerance should have a significant impact on what a portfolio looks like.
For example, a conservative investor might favor a portfolio with large-cap value stocks, broad-based market index funds, investment-grade bonds, and a position in liquid, high-grade cash equivalents. In contrast, a risk-tolerant investor might add some small-cap growth stocks to an aggressive, large-cap growth stock position, assume some high-yield bond exposure, and look to real estate, international and alternative investment opportunities for his portfolio.
In general, an investor should minimize exposure to securities or asset classes whose volatility makes him uncomfortable.
Impact of Time Horizon on Portfolio Allocations
Similar to risk tolerance, investors should consider how long they have to invest when building a portfolio. Investors should generally be moving to a more conservative asset allocation as the goal date approaches, to protect the portfolio's principal that has been built up to that point.
For example, an investor saving for retirement may be planning to leave the workforce in five years. Despite the investor's comfort level investing in stocks and other risky securities, he may want to invest a larger portion of the portfolio's balance in more conservative assets such as bonds and cash, to help protect what has already been saved. Conversely, an individual just entering the workforce may want to invest his entire portfolio in stocks, since he may have decades to invest, and has the ability to ride out some of the market's short-term volatility.
Both risk tolerance and time horizon should be considered when choosing investments to fill out a portfolio.