Investment portfolio

A portfolio is everything you own as an investment: shares, funds, bonds, cash, perhaps property. What matters is that you look at it as one whole.

An individual investment is neither good nor bad on its own. It takes on meaning through what it does to the whole: whether it raises the risk or balances it.

Asset allocation

The most important decision is not which share to buy but what proportion of your wealth goes into each asset class. That is called allocation.

Shares

A stake in companies. The highest expected return over the long run, but also the highest volatility.

Bonds

A loan to a state or a company. A lower return and smaller swings: in a portfolio they act as a shock absorber.

Cash

An immediately available reserve. It earns almost nothing and inflation eats its purchasing power, but it lets you avoid panicking when the market falls.

A worked example

Two people invest the same €50,000 for twenty years.

Portfolio A: 100% shares. A higher expected return, but in a bad year the value can fall 40%, that is €20,000.

Portfolio B: 60% shares, 40% bonds. A lower expected return, a fall of around 20% in a bad year.

At an average real return of 6% against 4.5%, portfolio A ends at €160,357 and portfolio B at €120,618.

The gap is considerable, but the relevant question is not which figure is higher. It is whether you could hold on without selling through a €20,000 fall. A portfolio you abandon at the worst moment has a deeply negative real return.

Why composition beats selection

Research shows again and again that the great majority of the variation in a portfolio's results is explained by the allocation between asset classes, not by the choice of individual holdings. Put differently: the ratio of shares to bonds decides more than which shares you buy.

That is good news: choosing a sensible ratio is far easier than picking a winning company.

Rebalancing

Over time the proportions drift on their own: when shares grow faster, their share of the portfolio rises and so does the risk you carry. Rebalancing means putting the ratio back: selling part of what has grown and topping up what has lagged.

It is usually done once a year, or when the drift passes a set threshold. A side effect is that it forces you to sell high and buy low, precisely the opposite of what instinct suggests.

What to watch out for

The most common mistake is mistaking the number of positions for diversification. Ten funds holding the same American technology companies is one bet spread across ten accounts.

The second is changing the allocation with the mood of the market. The ratio should be set by your horizon and your tolerance for a fall, not by headlines.

How a portfolio grows at different returns and contributions is shown by the compound interest calculator.