The Step by Step Portfolio Planning Process

Fact checked by Vikki VelasquezReviewed by Pamela RodriguezFact checked by Vikki VelasquezReviewed by Pamela Rodriguez

Few things are more important and more daunting than creating a long-term investment strategy so you can invest confidently. Planning your investments doesn’t have to be overwhelming. Taking a step at a time, you can build a foundation to grow wealth.

Constructing an investment portfolio requires a deliberate and precise portfolio-planning process that follows these five essential steps.

Key Takeaways

• Before you can plan for the future, you need to take a hard look at the present, sifting through all your assets, investments, and debt. Then, you can set clear short-term and long-term financial goals.
• Determine your risk tolerance and desired investment returns.
• Establish benchmarks to track your portfolio’s performance based on your risk-return profile.
• Create a diversified asset allocation strategy to maximize returns and adjust it as your life circumstances change.
• Decide between actively managing your portfolio yourself (picking your own mix of securities) or having fund managers do this for you.
• Monitor your investments and reassess your goals annually, adjusting when necessary.

Step 1: Get Real About Your Finances

First, you need to get a clear understanding of where you are financially and compare that with where you want to be. This means pulling together all the materials you need to calculate your assets, liabilities or debts, cash flow, and investments and examining them in light of your most important goals.

Here’s the information you’ll need:

• Assets: What do you own? This could include savings accounts, investment portfolios, real estate, and valuable personal property. For many, this might not be much—if anything—since that’s frequently the point of starting to build a portfolio.
• Liabilities: What do you owe? List any outstanding debts: student loans, credit card balances, and mortgages.
• Cash flow: How much money is coming in and going out each month? Analyze your income sources and expenses. Most banks and credit card companies allow you to download your transactions in spreadsheet form. Review your monthly spending and income sources for at least six months (a year is better). This has a way of making you more realistic about what you typically spend and how much you make—not what you wish you did.
• Investments: What does your present investment portfolio look like? Consider the types you have and their performance.

Next, list your financial goals. Be specific and quantify them whenever possible. For example, instead of simply saying, “I want to retire comfortably,” define what “comfortably” means for you. Is it having a certain amount saved in your retirement account? Is it being able to travel twice a year? Putting numbers to your goals makes them more tangible and easier to work toward. (Don’t know where to start? See our How Much Do I Need to Save to Retire?)

The more precise the picture you have of your current situation and future goals, the more effective your investment strategy will be. You can see the gaps between your investments, spending habits, income, and goals. This is also the time for a frank discussion about your values and priorities. Your investment strategy should align with what’s most important to you.

Important

Portfolio planning is not a one-and-done deal. It requires ongoing assessments and adjustments as you go through different stages of life.

Step 2: Set Down Your Investment Goals

Now that you have a clearer picture of your present finances, it’s time to establish your financial objectives. This step involves translating your personal goals into specific, actionable investment targets.

Start by revisiting the goals you identified in Step 1. Perhaps you aim to retire comfortably at age 65, buy a vacation home in the next 10 years, or fund your children’s college education. Whatever your goals, your investment objectives should be designed to help you achieve them.

Time Horizon

Next, consider your time horizon for each goal. How many years do you have to invest before you’ll need to access your funds? This will influence the types of investments you choose. For example, if you’re saving for a down payment on a house in the next five to 10 years, you’ll likely want to choose more conservative investments than if you’re saving for retirement in 30 years. That’s because the closer the date you’ve set for your goals, the less risk you can take on since you won’t have as much time to recoup potential losses.

Risk-Return Profile

Also crucial is determining your risk-return profile. This involves assessing how much risk you’re willing and able to take on and how much volatility you can withstand. Some people are comfortable with the idea of potentially losing money in the short term in exchange for the possibility of higher returns in the long run. Others prefer a more conservative approach, in which case you might favor a more balanced approach with a mix of stocks and bonds. Also, consider your tolerance for volatility. The market will inevitably experience ups and downs—how well can you stomach these fluctuations? If seeing your portfolio’s value temporarily drop would keep you up at night, you might prefer less risk or investments you don’t have to check very often.

Benchmarking

Once you’ve determined this profile, you can establish benchmarks to track your portfolio’s performance. These benchmarks serve as a measuring stick, allowing you to gauge whether your investments are performing as expected. For example, if you’ve decided on a moderate risk-return profile, you might choose a benchmark that reflects a balanced portfolio of stocks and bonds. If your portfolio consistently underperforms or outperforms this benchmark, it will signal that you need to adjust your portfolio, or your benchmark doesn’t fit it. (Need help figuring out a benchmark? See our How to Select and Build a Benchmark to Measure Portfolio Performance for ideas.)

Establishing your investment goals is not a one-time thing. As your life changes, your risk-return profile may shift as well. Regularly revisiting and refining your objectives will help ensure your investments align with your needs and goals.

Step 3: Decide What Assets You’ll Invest In

This is when you’ll divide your investment portfolio among different assets, such as stocks, bonds, cash, and alternative investments, based on your goals, risk tolerance, and investment timeline. You’re not yet picking specific stocks, bonds, etc., but the amount of your portfolio each type will take up.

Allocating assets for a portfolio involves diversification. By spreading your investments across different asset classes, you can lessen the chance that any one area of your portfolio will take down the whole of it. This is because different asset classes tend to perform very differently under the same market conditions. For example, when stocks are down, bonds are typically up, and vice versa.

To create your asset allocation strategy, start by assigning percentages to each asset class based on your risk-return profile. A more aggressive investor would allocate a higher percentage to stocks, which offer the potential for higher returns but also have more risk. A more conservative investor, meanwhile, might favor a larger allocation to bonds, which generally provide more stability but lower returns. Here are examples of ways to allocate assets based on different risk tolerances:

Alternative investments refer to assets that fall outside the traditional categories of stocks, bonds, and cash: real estate, commodities, currencies (including cryptocurrencies), private equity, or hedge funds.

Risk varies within asset classes as well. For example, some stocks, such as those of large, well-established companies (called “blue chips“), generally have less risk than stocks of smaller, newer companies. Similarly, government bonds typically have less risk than corporate bonds. Below is a cheat sheet on the relative risk of different assets.

Remember, your asset allocation strategy is the backbone of your investment plan. By diversifying your investments and regularly reassessing your strategy, you’ll be better positioned to weather market ups and downs and achieve your long-term financial objectives. In addition, if you buy shares in a mutual or exchange-traded fund (ETF) that holds these assets, your risk from that fund will be similar.

For this and other steps, don’t hesitate to get guidance from a financial professional who can help you develop a diversified portfolio that aligns with your needs and goals.

Step 4: Select Specific Investments

With your asset allocation strategy in place, it’s time to choose the particular assets you’ll have in your portfolio. If you’ve chosen 30% should be bonds—which bonds? If 60% stocks—which stocks?

The first thing to decide in this step is whether you want to actively manage your portfolio or not. This choice will then affect everything else you do:

Actively Managing Your Portfolio

Actively managing your portfolio means taking a hands-on approach. You’re directly involved in deciding what assets to buy (and later sell), typically through a mix of stocks, bonds, and other investments. However, building a favorably diversified portfolio—it’s common to say you need at least 25 to 30 different equities to diversify enough across sectors and geography—requires a lot of time and funds upfront. And that’s before you get to your portfolio’s other asset classes.

Passively Managing Your Portfolio

If you don’t have the time or the funds to do that on your own, you’ll want to consider passively managing your portfolio by investing in mutual and exchange-traded funds (ETFs) as a cost-effective and timesaving way to gain instant exposure to a diversified set of assets. These funds pool money from investors like you to buy a basket of securities.

To add some confusion we’ll clear up quickly: these funds are split among active and passively managed funds. It means the same thing as for your portfolio: if you’ve chosen this route, you’re already passively investing in a fund with a basket of securities. Now, that basket itself can be an actively managed fund (in which case, the fund’s management is trading the securities to meet its profile) or a passively managed one, which means that what’s in the index isn’t decided by the managers, but by mirroring an index like the S&P 500.

Actively managed funds are overseen by professional fund managers who aim to beat market benchmarks through strategic investment decisions. Passively managed funds seek to match market benchmarks. The latter are almost always index funds, which can be an excellent choice for many picking their first investments. These are designed to track the performance of a specific market index, such as the S&P 500 for U.S. stocks or the Bloomberg Barclays U.S. Aggregate Bond Index for U.S. bonds.

You can also buy shares in index funds that represent various asset classes and economic sectors to construct a well-diversified portfolio. For each part of your asset allocation, you can buy a percentage in a fund that matches diversification for stocks, bonds, etc. You can also find ETFs and mutual funds that are diversified across assets so that you might be comfortable with them making up much of your own portfolio. Many Americans do this with each paycheck, as they put more money into target-date funds (funds that are actively managed to change over time to meet a specific retirement date) that make up much of their own portfolio. (For more help in this area, see our How to Pick Your Investments.)

Note

Your risk-reward profile will change over the years, tilting further away from risk the closer you get to retirement.

Step 5: Monitor, Measure, Rebalance

The key to long-term investing lies in ongoing management—even if you’re “passively” managing your portfolio. This includes monitoring your investments, measuring performance, and adjusting as needed. To ensure your portfolio is on track, you’ll need to regularly check on your investments and measure their performance against the benchmarks you established in Step 2, whether quarterly or semiannually. When assessing your portfolio’s performance, you’ll want to ask the following:

1. How have your investments performed compared with their benchmarks?
2. Are your investments maintaining the desired level of risk?
3. Is your portfolio still well-diversified across asset classes and sectors?
4. Are you minimizing investment costs and fees?

Each year, you’ll review your portfolio and also address any broader changes in perspective you might have:

1. Have your financial goals or time horizons changed?
2. Has your risk tolerance shifted because of changes in your personal or financial circumstances?
3. Are your investments still aligned with your target asset allocation?

If your annual review reveals that your portfolio no longer aligns with your risk-reward profile or target allocation, it’s time to rebalance. This means selling investments that have exceeded their target allocations and buying investments that are underrepresented in your portfolio. For example, if your target allocation is 60% stocks and 40% bonds, and changes in the market mean your portfolio is now 70% stocks and 30% bonds, you’ll need to sell some stocks and buy more bonds to restore your original allocation.

When investing to reach lifelong objectives, the portfolio planning process never stops. Many events could change your outlook and needs as you move through your life. As these occur or as market and economic conditions dictate, the portfolio planning process begins anew. At that point, you can restart these five steps to ensure that you have the right investment strategy in place.

What Is the Importance of an Annual Reassessment of Financial Goals?

Annual reassessment allows you to adapt to changes in your financial situation or objectives, ensuring your investment strategy remains aligned with your goals.

What Is the Key To Successful Portfolio Monitoring?

Successful portfolio monitoring involves regular reviews, understanding market changes, and adjusting strategies to stay aligned with your financial goals.

How Does Buying a Home Affect My Investment Strategy?

Purchasing a home is a significant event in your life and for your portfolio since whatever part of the home you own (called the “home equity“) is now essentially part of your investment portfolio. You may need to shift some of your investments toward more liquid and stable assets to ensure you have enough funds for the down payment, closing costs, and ongoing mortgage payments.

This may involve temporarily reducing your exposure to riskier assets, such as stocks, and increasing your allocation to cash or short-term bonds. As you update your investment strategy to accommodate your home purchase, consider how your home equity and mortgage fit into your overall asset allocation and long-term financial goals. Maintaining a diversified portfolio is essential while recognizing that your home can play a significant role in your financial security and wealth-building efforts over time.

The Bottom Line

Creating a successful investment portfolio requires careful planning and ongoing management. By following the five steps outlined in this article, you’ll have in place a personalized investment strategy that aligns with your financial goals, risk tolerance, and life circumstances.

The first step is to assess your present financial situation and set clear, quantifiable investment goals. Next, establish your risk-return profile to determine the appropriate balance between potential rewards and acceptable levels of risk. You can then allocate your assets in a diversified manner. When selecting specific investments, consider your preference for active or passive management. Finally, remember that portfolio planning is an ongoing process that requires regular monitoring, performance measurement, and rebalancing.

As you move through different stages of life, your financial goals and circumstances may change, requiring adjustments. At each point, don’t hesitate to seek guidance from a trusted financial professional who can provide valuable insights and support throughout your investment journey.

Read the original article on Investopedia.