Lesson 6

How to build a portfolio

You’ve learned about stocks, brokers, bonds, and ETFs. Now let’s put it all together, and figure out how to build a portfolio that suits your needs.

What you’ll learn this chapter:

  • What makes a good portfolio
  • What risk is and how to figure out your risk profile
  • How to manage your portfolio once you’ve built it

What is a portfolio?

You might think of a portfolio as only the stocks you’ve invested in. But really, a portfolio is anything you own that might increase in value. That includes the obvious stuff: stocks, bonds, money in a savings account with interest. But it can also include something like real estate if you own a house or apartment, gold jewelry, and even Pokémon cards, if you still have some rare ones lying around.

Things that don’t count include cars, which tend to depreciate in value unless they’re vintage or collector items, and money that’s just in your checking account.

Each of the items in your portfolio have their quirks: real estate investments can double as a place to live. That’s usually what they are for most people who own one house or apartment. In that case, you’re saving on rent as well as building your stake in an asset that might lose or gain value. But the value of that asset isn’t all there is, as even if the value drops, you still have a roof over your head.

For now, we’re going to focus on the part of the portfolio that’s made up of stocks, bonds, ETFs and the like. But if you need advice on Pokémon cards, you can absolutely get in touch with me, Oliver, personally.

What is risk and how to manage it

Building a portfolio is all about risk. There are two kinds of risk: upside and downside. Let’s say you hold a stock, and your expectation is that it will go up or down roughly 5% over the next year. The upside risk is the chance that it will go up more than 5%. The downside risk is that it will lose more than 5%. A higher upside risk is usually correlated with a higher downside risk. So if you want bigger gains, you have to be prepared for bigger losses.

There are no guarantees for how risky an asset is. After all, something completely unexpected can happen and even the safest-seeming asset can lose all its value. But generally, the risk spectrum goes like this, from riskiest to least risky: stocks, ETFs, bonds, savings accounts. There are nuances within each category: some stocks are more risky than others, as are some bonds or ETFs. A very risky bond might be riskier than a slightly risky stock.

Savings accounts are usually insured by the state up to a certain amount, which means that even if your bank goes under, you get your money back. Bonds have a whole spectrum of riskiness — they’re rated by credit agencies because of that, but when you’re talking about government bonds, you’re usually safe to assume you’ll get your money unless the state goes bankrupt.

ETFs that carry stocks are vulnerable to market swings. If the stock market has a bad day, no amount of diversification will protect your ETF from losing money. And then there are stocks, which can have explosive growth, as well as very quick tumbles.

Remember too that ETFs can also carry bonds, which would put them more into the bond category. But the most popular ETFs are pure stock ETFs, so that’s what we’ll talk about for the sake of simplicity.

Figuring out what percentage of stocks, bonds and ETFs to have in your portfolio is called diversification.

Figuring out an objective

One of the best ways to figure out your risk appetite is to know what your objective is. Are you hoping for some extra income? Are you saving up to buy an apartment or house? Or are you thinking about retirement? Each of these goals has a different time frame and importance.

The shorter the time frame, and the more crucial the goal, the lower the risk you can tolerate. For example, if you want extra income, but can survive without it, you can tolerate having a month where you don’t get any income.

If you’re saving up for a house, and you have a few years, you can tolerate some moderate risk, as a drop in your assets could recover in time. Stil, you do need to eventually meet your goal.  

If you’re saving for retirement, you obviously need to meet your goal by a certain day. But depending on your age, you also have time to meet that goal. When you’re still decades away, you can afford more risk. But the closer you get to retirement, the less you can afford to lose that money.

If you’re not sure what your goal is or don’t have a time frame in mind, there’s an old rule you can follow. 100 minus your age = % of stocks in your portfolio, and the rest in bonds or a savings account. If you’re 35, you can invest up to 65% in stocks. if you’re 65, you put 35% in. This isn’t an ironclad rule, but a basic principle you can consider.

The reasoning here is that over long periods of time, stock returns outpace bond returns, even with volatility calculated in. If you invested just before the financial crash of 2008 but kept your investments, you eventually made up the money lost in the crash and then gained a lot after. So if you have the time to hold, you can tolerate more risk. As your time horizon shrinks, you lose the time to make up losses, and with it your tolerance for risk.

How to diversify

There are more ways to diversify than just choosing between stock and bonds. Companies work in different industries and countries, and you can diversify that risk by investing in a variety of both.

If you’re diversifying industries, look for both cyclical and counter cyclical ones. Cyclical industries do well when the economy is booming, and worse of it isn’t. A good example is the airline industry: when times are good, people travel more, and airlines make more money. When the economy is down, and people and companies are looking to scale back expenses, travel is often the first thing to go, which hits the airlines hard.

Counter-cylical industries tend to do the same whether the economy is good or bad, or they’ll even perform slightly better when times are tough. These companies make products that need to be bought anyway. A discount retailer, and grocery stores in general, will tend to keep making money or even more money when the economy shrinks and people get laid off, because everyone still needs to buy food, and might buy even more as they scale back how much they spend on dining out.

Diversifying by countries can also help reduce risk. Sometimes an economic situation is global, like the coronavirus pandemic, but often you’ll find regions that are harder hit than others. China, for example, has been able to bounce back faster from the economic downturn caused by the pandemic, leading to a boon for companies there as well as those whose business is dependent on the Chinese market.

That’s it. You’ve learned all we have to teach you, at least for now. One more test and you’re ready to hit the ground running.

What's next?

It's time for a quiz!

You now understand the basics. Let’s test your knowledge, and then go a bit deeper.
Your result

It's time for a quiz!

You now understand the basics. Let’s test your knowledge, and then go a bit deeper.




It's a bit early to start this lesson

Our lessons built to be finished in order. Every lesson requires some knowledge from a previous one. Please procede to the last lesson you’ve started.