Welcome to the fifth part in the intermediate guide to investing! By now, we have learnt how to read financial reports and have a working understanding on how to evaluate investment products like stocks.

By the way, if you haven't yet read our beginner's guide to investing, where we introduce things like why you should invest, how to start investing, risks, rewards and strategies, do check it out first!

Why Invest? - Beginner’s Guide To Investing (Part 1) | Investing For Two
Welcome to the first part in Investing For Two’s beginner’s guide to investing! It’s always an exciting journey to learn something new, and investing is something you definitely want to pick up earlier rather than later in your life. This guide will walk you through the basics of investing, all the…

Chapters in this guide:
Part 1 - Why Read Financial Statements?
Part 2 - How To Read Financial Statements
Part 3 - 10 Key Financial Ratios & Metrics
Part 4 - How To Analyze A Stock
Part 5 - Portfolio Management & Asset Allocation
Part 6 - Portfolio Rebalancing & Market Conditions
Resource - Stock Analysis Checklist

Through analyzing the underlying business, checking the financial data, and cross checking expert opinions, we are able to reduce the risks we have in the long term when picking a stock to invest in.

In the previous parts, we focused a lot on picking out stocks with good financial prospects. However, even with all the data in the world, even investment hedge firms can face great losses when unexpected things happen to the market.

The most important thing while investing is to know how to protect ourselves while growing wealth, not how to pick stocks. Remember, the core of investing is to allow you to achieve your financial goals, not to gamble.

Nowadays, there are so many investment products to choose from. ETFs, REITs, equities, bonds, foreign currency, commodities... the list goes on and on. How do we know what to choose, and when?

In this part, we will explore what a portfolio is and why portfolio allocation is important. We will also see how different investment products achieve different goals, and how to construct a portfolio allocation to suit your investing needs and goals.

What is a portfolio?

A portfolio simply means a collection of financial instruments that one owns. This can include various investment products, from equities to real estate, to bonds and even just plain old cash.

Well, why do we need such a collection of financial instruments? Why can't we just go all in on a single stock? You probably already know the answer.

In part 2 of our beginner's guide to investing, we examined the various risks that one faces when investing. Generally, risks can be categorized into two broad types: firm-specific risks (specific to a company or industry), and market risks (affecting the whole market).

There, we examined how a diversified portfolio can help to reduce some of these investing risks.

For example, by having stocks in different sectors, you reduce the amount of firm-specific risks you face because if one sector falters, others may still do well.

A similar concept applies to returns. If we had only invested solely into a single stock, we would be subjected to 100% of its returns. If it does well, then great! But what if it doesn't do so well? Or what if another sector does better?

As the saying goes:

Don't put all your eggs in one basket.

By diversifying the investments in our portfolio, we ensure that we are not overly dependent on any one particular sector's returns, while also making sure that we do not suffer overexposure to particular risks (of a specific sector, for example).

The concept of portfolio optimization

Now that we understand why a diversified portfolio is important, let us further look at the concept of portfolio optimization.

Generally speaking, a modern portfolio comprises of two types of portfolios:

  1. Performance seeking portfolios (PSP)
    As the name suggests, the goal of this portfolio is to create the highest returns possible for the investor to earn money.
  2. Liability hedging portfolio (LHP)
    This portfolio seeks to protect the owner from liabilities and risks. The goal here is to generate cash flow such that it covers the liabilities faced by the owner.

Let's explain the liability hedging portfolio a bit further.

Simply put, the cash flows generated by the assets in a liability hedging portfolio seeks to perfectly cover and thus protect against the outwards cash flow caused by liabilities.

For example, if I have to pay a liability such as utility bills every month, then I'll seek to generate enough cash flow through my investment assets to cover that.

To keep things simple, let us just regard a performance seeking portfolio as a portfolio aimed at making money, and a liability hedging portfolio as a portfolio aimed at minimizing our risks by protecting our financial stability.

Our goal here is to balance these two types of portfolios within our larger portfolio in order to achieve the highest returns possible while maintaining an acceptable level of risk that we are comfortable with.

For example, if we have financial instruments looking to make a great profit with relatively higher risk (such as individual stocks), then we should have a corresponding financial instrument that provides lesser returns but with lower risk in order to serve as insurance.

The ratio between the amount of financial instruments for profit and the amount of financial instruments used to protect yourself against risks depends on your risk tolerance and financial goals.

Types of financial securities

According to the modern portfolio theory, the rate of return is proportional to the level of risk incurred by the investor. High risk, high reward.

As such, we generally classify financial securities with higher risks to be performance seeking, and securities with lower risks and stable cash flow payouts to be liability hedging (though there may be exceptions).

Choosing a mix and match of multiple types of financial securities will help in building up a diversified portfolio that matches your goals (more on that later).

First, let us attempt to classify various popular financial securities and see which type of portfolio they might belong in.

Performance seeking

Growth Equities (Stocks)
Individual equities are performance seeking since we pick out specific stocks in order to beat the market. Often, we are looking for growth in order to get more capital gain. They generally perform well in times of economic prosperity and vice versa.

REITs
Real estate investment trusts are also performance seeking since they are actively managed. The trust managers seek out properties in order to increase the growth of the managed portfolio. While REITs pay out dividends, they cannot be termed as stable, and are hence performance seeking instead of liability hedging.

Similar to stocks, REITs do well in times of economic prosperity since there are tenants to rent, and badly if times are hard.

Real estate
Similarly, purchasing real estate for rent or resale is for profit. We expect real estate to appreciate in value, giving us capital gains. However, real estate can be seen as liability hedging as well, since rents are a form of monthly payment that is relatively stable.

They are relatively stable in most economic situations unless there's a real estate bubble. Generally, they do not suffer as much in times of economic downturn.

Options
When taking up options, investors have a choice between going long or short. A long position means that you set a price to purchase a financial instrument now. In the long term, if the price goes up, you are getting gains since you just have to pay the amount promised previously for more value.

Conversely, a short position means that you set a price to sell a financial instrument now. You want the price to go down, since that means that you gain a profit on the sale later on.

Options are definitely performance seeking, since you are actively trying to earn money, and contains high risk, and high rewards.

Depending on the position you take, they can either do very well or very badly in all economic conditions.

Foreign currency
When trading Forex, we are definitely going with profits. Since increments and decrements are relatively small, investors generally use margins (money they don't have) to trade in larger volumes. As such, this is a profit seeking method with one of the most liquid markets in the world.

Depending on the currency, the performance varies. When times are bad, the US dollar actually increases in value since it's the reserve currency of the world. Other currencies might not fare so well, however.

Commodities
In general, while commodities can be used for inflationary hedging (protection against inflation risk), due to the high volatility associated with commodity trading like crude oil, they are usually for profit and are not stable enough (low risk) to be considered as liability hedging.

Their performance varies during times of changing economic landscapes, and varies wildly depending on industry as well.

Liability hedging

ETFs
Since exchange traded funds track the market, it is a form of passive investment as we aren't trying to actively beat the market's return. As such, it's a form of liability hedging since they exhibit relatively stable growth in the long term.

Therefore, they can be useful to protect against inflationary risks (returns are similar or higher than the rate of inflation). They generally perform like equities (good when good, bad when bad) but to a lesser extent.

Gold
You may have heard of a lot of people "escaping" to gold when the markets turn bad. Gold is a precious metal that has its value unchanged over many generations. Gold prices tend to rise along with inflation, making it useful to combat inflationary risk.

Gold also tend to do well when the markets are in turmoil - since everyone seeks the safety of cash (they don't want to invest), and gold is by far one of the safest ways to hoard cash. Thus, gold serves as a sort of protection and insurance in times of lacking confidence.

Bonds
Bonds also provide a stable coupon payout, along with the principal face value at the end of the bond duration. As such, stable bonds (not junk bonds) can be seen as liability hedging since the stable, expected returns generate cash flow to offset required liabilities.

They do the best in times of economic downturn, and generally underperform most other financial instruments when times are good.

Dividend paying equities
While equities are profit seeking, they can be regarded as liability hedging as well. Dividend aristocrats, stocks that have been stably paying and increasing their dividends for 25 consecutive years or more, can serve as a stable cash flow income to protect against liabilities.

They generally show their value when times are bad if dividends continue their payouts, while their performance during economic growth varies.

Cash
Naturally, we also have cash on this list. In uncertain times, such as a recession, investors love to hoard cash and gold to wait for better times to invest. Of course, you can also hoard cash if you think a recession is about to happen in order to get things at a discount.

Of course, hoarding too much cash is a bad thing as well. Since the cash is not being invested, it is slowly losing value due to inflation.

Risk vs reward

Of course, this is a non-exhaustive list of financial instruments. There are just too many things that you can invest in these days, but the above are some of the most common ones for individual investors.

Generally, we can see that performance seeking financial instruments tend to have higher risk or volatility, often making use of margins to try and achieve higher returns and beating the market.

Conversely, liability hedging investment products tend to have lower or more manageable risks, providing a steady stream of cash flow or returns that allow an investor to hedge or protect themselves against liabilities and other risks.

Naturally, the returns associated with liability hedging products are relatively lesser as well, in exchange for their stability.

As we can see, different investment products perform differently in varying market conditions as well, which we will examine further in the next part of this guide.

Risk tolerance & portfolio planning

Now that we have a more comprehensive distinction of various financial instruments and the types of portfolios they belong in, we can start planning our own portfolio containing a mix of these products.

Before you start picking random things, take note of your risk tolerance. Risk tolerance is dependent on several factors, including your age, your income, your investments and your liabilities.

Age
It is well known then the older you are, the less risk-tolerant you are. This is mainly due to the potential of income. When you're young, you have the potential to work and earn income, allowing you to take on more risks.

Graph of risk tolerance vs age
Risk tolerance vs age

When you're older or retired, it can be hard to find jobs or earn income. This makes your liabilities harder to meet.

As such, when younger, you will tend to skew your portfolio towards a performance seeking one, including adding more weight to equities, options and the likes.

When older, you tend to be more liability hedging to preserve your current lifestyle, including partaking in retirement bonds and dividend paying equities to preserve capital and generate cash flow.

Income
Similarly, your income decides the amount of risk you can take. With a higher income, you will naturally have more to spend in excess of your liabilities, allowing you the financial freedom to make more risky investments.

Risk tolerance vs income
Risk tolerance vs income

If you have lower income however, you will need to save more to offset situations of increased liability (sudden hospitalization, for example), and will not be able to take on as much risks.

Of course, your risk tolerance is proportional to how much you spend. Someone that earns a lot but spends most of it will end up with a risk tolerance that is low, since their liabilities are high as compared to their earnings.

Essentially, your risk tolerance is a representation of how much excess cash you have after covering for your recurring liabilities, as well as your ability to generate more cash.

Someone with low risk tolerance should take on more liability hedging investment products in order to offset their liabilities without taking on excess risk, while someone with high risk tolerance should take on more performance seeking investment products to generate more returns.

Investments
If you're someone whose investments already cover your liabilities, then it is appropriate for you to take on more risk. By investments, we mean stable investments that generate constant cash flow, such as real estate or bonds.

Income should not be regarded as investments since it can be lost at any time and requires you to actively work for it. Rather, look at passive cash flow sources that generate money for you by having your money work for you.

If these investments can cover your liabilities in excess, then you are eligible to take on more risk to start a business or taking on more risky investments.

This is because you have successfully hedged against your liabilities and are essentially financially free to do whatever you want without worrying about protecting your base standards of living.

The ideal goal is to move as much investments into performance seeking products as much as you can for your risk tolerance. After all, we are trying to get as much returns as we can based on a risk level that is acceptable to you.

Goal based optimization

The allocation of portfolio weights between performance seeking and liability hedging essentially depends on your risk tolerance as mentioned above.

Of course, you can decide to put more into performance seeking if you want to take on risk above your risk tolerance level - although that is highly ill advised.

When planning your portfolio allocation, it is also important to take into account your financial goals. What are you trying to achieve? By when must you achieve this goal?

Time horizon planning

Let's say you want to purchase a property for staying in by age 30. This house costs $500,000, but has a down payment of only $100,000. You are currently 20 years old with $10,000 to your name.

Within 10 years, you have to turn that $10,000 to $100,000. The 10 years is considered your time horizon for your goal.

Next, you will want to factor in possibilities, or income sources. Let's say you will have budgeted savings of $1,000 per month.

Ignoring inflation and other rates, you can expect to have $130,000 saved up over 10 years. This gives you an amount in excess of your financial goal, allowing you to make more risky investments to grow your wealth.

What if you need that house in 5 years instead? Well, you'll only have saved up $60,000, meaning that it will definitely not be enough.

According to a financial goal calculator, starting at $10,000 with $1,000 invested every month, you will need a rate of return of around 12% to have enough money just for the down payment of the house!

To achieve a return of 12%, you obviously have to take on more risks. As such, the time horizon for your financial goals determines the risk level you have to take. The longer the time horizon, the less risk you have (since you have a longer time to get the money you need) and vice versa.

Do match it against your risk tolerance and check if your financial goals are realistic enough. If you have to take on risk beyond your risk tolerance, then you might be aiming for too much.

Planning your portfolio weights

Obviously, this example is a bit simplistic and doesn't account for many things, but the concept still stands.

You will want to come up with your financial goals, and end up with the final amount of money that you need with a time horizon.

Next, you will want to evaluate your current risk tolerance and match it against the risks that you will have to take in order to achieve the returns required to reach your financial goal.

If you think the risk is too high compared to your risk tolerance, that's when you have to re-evaluate your financial goals.

That said, how do we get a general idea of the risks we have to take to reach our financial goals?

It mainly has to do with the way we structure our portfolio between various investment products.

From the above example, we require a rate of return of 12% to reach our financial goal. We know this is already quite high, meaning the risks we have to take is probably immense - getting a house within 5 years is highly risky.

To make it more realistic, let's assume we need a decent 8% rate of return as an example.

Next, we will need to allocate the portfolio distribution to match this 8% rate of return. First, let us arbitrarily allocate various investment products that we want to use in our portfolio.

Let's say we want to use stocks. Stocks historically have an average return of 10%, which is higher than 8%. Of course, historical results don't reflect future results, but we can use it as a benchmark.

Since the historical returns are more than what we need, we can assume that stocks, as a performance seeking investment product, carries "more risk" than what we are required to carry (we only need an 8% return).

In turn, we can balance that out with some liability hedging products to lower our risk level while achieving the returns we need. This is why diversification is important - to lower our risk.

There is no point taking on more risks than we require - that would move investing into the realms of gambling, and we don't want to do that.

Let's say we choose to use bonds (it can be anything, really). Bonds on average have a 5% return (estimated), meaning it should carry lower risk.

We now have to balance the weights of stocks and bonds in our portfolio to achieve the appropriate 8% rate of return with minimum risk.

10% * X + 5% * Y = 8%

X and Y denotes the weights of stock and bonds respectively in our portfolio. Basically, we are trying to find the weighted average of their returns to achieve the one we want.

Solving, we get that we need 60% of stocks and 40% of bonds to achieve an 8% expected rate of return, meaning that we can choose to allocate our portfolio in such a way to minimize the risks required for our returns.

Of course, this is an expected rate of return, and is subject to be wrong due to market volatility, the economic landscape, external news and so on.

Additionally and importantly, since we are relying on the historical average of an entire investment product (e.g. stocks), the individual stock or ETF you pick out must still undergo scrutiny from you to determine if it's safe to invest in.

The one you pick out within that investment product category may not exhibit the same expected rate of return, so be sure to do your own diligence.

You can use methods from previous parts of this guide to achieve that to a certain degree.

In this example, there's only two types of investment products, but your portfolio will likely have more. At that point, you should come up with arbitrary weights that fit your risk tolerance to determine your portfolio allocation.

Summary

These days, there are many algorithms and AI that try to attempt to help you allocate your portfolio, like robo-advisors. If you don't want to think about it at all, and if the above seems too tiring to do, it is okay to consider those solutions as well.

Remember, investing is a way for you to reach your goals (not just financial ones), not something that gets in the way of them. While investing is important, don't let it become something that sucks the joy out of your life.

That said, make sure your financial goals are achievable. You should not have to take on risks that outweigh your risk tolerance to be able to reach them.

By now, we have introduced the basics of portfolio allocation. After identifying your financial goals and risk tolerance, you can come up with a portfolio allocation that suits your needs.

You may have noticed something important though - this is just an initial portfolio allocation. However, we know that markets tend to change, often unpredictably. How can we ensure that our portfolio allocation keeps us on track to reach our goals?

As the markets and economic landscape changes, we too have to change our portfolio to keep our risk levels manageable while not hurting our returns too much. This is known as portfolio rebalancing.

In part 6 of our intermediate guide to investing, we will examine portfolio rebalancing in greater detail as well as how to deal with changing market conditions as an investor.

Portfolio Rebalancing & Market Conditions - Intermediate Guide To Investing (Part 6) | InvestingForTwo
Welcome to part six in the intermediate guide to investing! In the previous part, we learnt about planning financial goals that are achievable and coming up with a preliminary portfolio allocation to achieve those goals while respecting your risk tolerance. Also, if you haven’t yet read our beginne…

PS: We also have a stock analysis checklist for you to see if a stock is risky to invest in or not (of course, this is not definite, but it provides a baseline). Do check it out below!

Stock Analysis Checklist | InvestingForTwo
This is a checklist of things to check to see if a stock is good for investing or not. It provides a suggestion of financial metrics, ratios and other factors to take note of when analyzing a stock that you want to invest in. For more in-depth explanations on this checklist and the various financia…

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