Stock investors constantly hear about the wisdom of diversification. This concept simply means not putting all of your eggs in one basket, which helps mitigate risk and generally leads to better return on investment. Diversifying your hard-earned dollars does make sense, but there are different ways to diversify, and there are different portfolio types. It's important to understand that building any kind of portfolio will require research and some effort. Here is some basic information about five different portfolio types and how to get started with each.
The Aggressive Portfolio
An aggressive portfolio portfolio includes those stocks with a high-risk/high-reward proposition. Stocks in this category typically have a high beta, or sensitivity to the overall market. Higher beta stocks consistently experience larger fluctuations relative to the overall market. If your individual stock has a beta of 2.0, it will typically move twice as much as the overall market in either direction.
Most companies with aggressive stock offerings are in the early stages of growth and have a unique value proposition. Building an aggressive portfolio requires an investor who is willing to seek out such companies, because most of them, with a few exceptions, are not going to be common household names. Look online for companies with rapidly accelerating earnings growth have not been discovered by Wall Street. The most common sector to scrutinize would be technology, but many firms in other sectors pursuing an aggressive growth strategy can be considered. Risk management becomes very important when building and maintaining an aggressive portfolio. Keeping losses to a minimum and taking profit are keys to success in this type of investing. (For related reading, see: The Advantages of Investing in Aggressive Companies.)
The Defensive Portfolio
Defensive stocks do not usually carry a high beta and are fairly isolated from broad market movements. Cyclical stocks, on the other hand, are those that are most sensitive to the underlying economic business cycle. For example, during recessionary times, companies that make the basic necessities tend to do better than those focused on fads or luxuries. Despite how bad the economy is, companies that make products essential to everyday life will survive. Think of the essentials in your everyday life and find the companies that make these consumer staple products.
The benefit of buying cyclical stocks is they offer an extra level of protection against detrimental events. Just listen to the business news and you will hear portfolios managers talking about "drugs," "defense" and "tobacco." These really are just baskets of stocks the managers are recommending based upon where the business cycle is currently and where they think it is going. However, the products and services of these companies are in constant demand. Many of these companies offer a dividend as well which helps minimize capital losses. A defensive portfolio is prudent for most investors. (For more, see: Guard Your Portfolio With Defensive Stocks.)
The Income Portfolio
An income portfolio focuses on making money through dividends or other types of distributions to stakeholders. These companies are somewhat like the safe defensive stocks but should offer higher yields. An income portfolio should generate positive cash flow. Real estate investment trusts (REITs) and master limited partnerships (MLP) are excellent sources of income-producing investments. These companies return a great majority of their profits back to shareholders in exchange for favorable tax status. REITs are an easy way to invest in real estate without the hassles of owning real property. Keep in mind, however, these stocks are also subject to the economic climate. REITs are groups of stocks that take a beating during an economic downturn, as real estate building and buying activity dries up.
An income portfolio is a nice complement to most people's paycheck or other retirement income. Investors should be on the lookout for stocks that have fallen out of favor and have still maintained a high dividend policy. These are the companies that can not only supplement income but also provide capital gains. Utilities and other slow growth industries are an ideal place to start your search. (For related reading, see: Dividends Still Look Good After All These Years.)
The Speculative Portfolio
A speculative portfolio is closest to a pure gamble. A speculative portfolio presents more risk than any others discussed here. Finance gurus suggest that a maximum of 10% of one's investable assets be used to fund a speculative portfolio. Speculative "plays" could be initial public offerings (IPOs) or stocks that are rumored to be takeover targets. Technology or health care firms in the process of researching a breakthrough product, or a junior oil company about to release its initial production results would also fall into this category.
One could argue that the widespread popularity of leveraged ETFs in today's markets represent speculation. Again, these types of investments are alluring because picking the right one could lead to huge profits in a short amount of time. Speculation may be the one portfolio that, to be done successfully, requires the most homework. Speculative stocks are typically trades, not your classic buy-and-hold investment.
The Hybrid Portfolio
Building a hybrid portfolio means venturing into other investments, such as bonds, commodities, real estate and even art. There is a lot of flexibility in the hybrid portfolio approach. Traditionally, this type of portfolio would contain blue chip stocks and some high grade government or corporate bonds. REITs and MLPs may also be an investable theme for the balanced portfolio. A common fixed income investment strategy approach advocates buying bonds with various maturity dates and is essentially a diversification approach within the bond asset class itself. Basically, a hybrid portfolio would include a mix of stocks and bonds in relatively fixed proportions. This type of approach offers diversification across multiple asset classes, which is beneficial because equities and fixed income securities tend to have a negative correlation with one another. (For related reading, see: An Introduction to Investment Diversification.)
The Bottom Line
At the end of the day, investors should consider all of these portfolios and decide on the right allocation across all five. Building an investment portfolio does require more effort than a passive, index investing approach. By going it alone, you will be required to monitor your portfolio(s) and rebalance more frequently, thus racking up commission fees. Too much or too little exposure to any portfolio type introduces additional risks. Despite the extra required effort, defining and building a portfolio will increase your investing confidence, and give you control over your finances. (For related reading, see: 4 Steps to Building a Profitable Portfolio.)