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Course 502
Building a Portfolio, Part 2


As discussed in Stocks 501: Building a Portfolio, Part 1, the first step in building a portfolio of stocks is to determine your investment objectives, or, in other words, to establish what your expected return and acceptable risk tolerance is for the portfolio. Next, you need to look at the constraints that may be involved when building your portfolio. There are four constraints to consider: your time horizon, your liquidity needs, your tax situation, and possible legal and regulatory issues.

Time Horizon

Your time horizon is perhaps the most important constraint. Time can be an investor's best friend--or worst enemy. The longer the time horizon, the more risk the portfolio can tolerate. In the short term, it is more difficult to recoup the loss of any one particular asset. Over the long term, however, the portfolio can make up for any losses with other assets that outperform over time.


Liquidity is the ability to readily convert an asset into cash. Examples of liquid assets are stocks and bonds. Examples of illiquid assets include real estate and venture capital. There is a key difference between real liquidity needs and perceived liquidity needs. Perceived liquidity needs include things that you may want but aren't really necessary. Real liquidity needs typically fall into one of the essential categories listed below, which you need to consider when developing your financial plan: Emergency Cash. Financial advisors recommend that you keep three to six months of spending cash on hand in case of an emergency. Set aside this money in a money market fund and do not consider it to be part of your investment portfolio. Goal Spending. Investments for short-term goals, such as those three to five years out, should be very liquid. Taxes. If you can estimate what you owe in income or estate taxes, set aside money in cash equivalents that mature no later than the due date. What about the taxes you'll have to pay on profitable positions that you have sold? Assets that are held for less than one year and then sold are taxed at the 15% capital-gains tax rate. Those held for 12 months or more are taxed at a 5% rate. It would make sense, then, to hold onto an investment for more than 12 months and enjoy the tax advantage. Investors with a significant concentration in one stock that has a low cost basis (which simply means a low purchase price relative to the stock's current price) will need to pay large capital-gains taxes at the time of sale. It may be tempting to defer the capital-gains tax indefinitely by just holding on to the investment. But be careful: The risk of loss from a portfolio that has a large concentration in one stock may outweigh the tax-timing decision. Instead, consider selling portions of the low-basis stock over time. This will reduce your investment risk while still deferring some of the taxes. Investment Flexibility. To be able to take advantage of market opportunities as they arise, make sure about two thirds of your portfolio can be liquidated within a few days or weeks.

Legal and Regulatory Issues

Legal and regulatory issues are not a major constraint for most investors building stock portfolios. If the portfolio is part of a trust, however, then certain restrictions may play a more prominent role. In that case, consult with a financial advisor.

Final Steps

When it comes to the constraints inherent in building a portfolio, there are no set rules to follow. The issues discussed above may be important for some individuals and not as significant for others. But all investors should recognize their constraints and structure their portfolios accordingly. The portfolio-building process is dynamic and constantly changing; as a result, the final steps in the portfolio process include monitoring and analyzing the portfolio. In doing so, you can adjust the portfolio to changing market conditions, if you'd like, or alter it as your goals change. You should also measure and compare the performance of your individual stocks and overall portfolio to relevant benchmarks. Compare your stocks' performances to market indexes and industries to get a sense of how the portfolio is performing. We include such benchmarks on our Stock Reports. Enter your portfolio in our Portfolio Manager to get a feel for how your investments, as a group, are performing. Are they generating the type of return that you need to reach your goals? If not, you may need to make some alterations.

Quiz 502
There is only one correct answer to each question.

1 Which of the following best describes real liquidity needs?
a. The amount of funds set aside for necessary expenditures, which are usually determined when setting up your overall financial plan.
b. The amount of water needed to quench ones thirst.
c. The amount of funds needed for goods and services that are wanted but unnecessary.
2 In order, name the general steps that make up the portfolio process:
a. Determining your objectives and goals, building the portfolio, making adjustments, and measuring performance.
b. Determining your objectives and goals, building the portfolio, monitoring and analyzing the portfolio (including measuring the performance of the portfolio), and making adjustments.
c. Building the portfolio, determining your objectives and goals, monitoring and analyzing the portfolio, measuring performance.
3 How much of your total portfolio should be invested in assets that are quickly and easily converted into cash?
a. None of the portfolio needs to be in assets that can be easily liquidated.
b. Less than one tenth of the portfolio should be kept in assets that can be easily liquidated.
c. Two thirds of the portfolio should be able to be liquidated within a few days or weeks.
4 Which is the best explanation of why time horizon is such an important constraint when building a portfolio?
a. The longer the time horizon of the portfolio, the more risk it can tolerate.
b. The length of your time horizon doesn't matter when building a portfolio.
c. In the short term, it's easy to recoup a loss in any one asset by investing in assets that will outperform.
5 If you have a very large position in a stock that you have held less than one year and you are worried about overconcentration in that company, what would we suggest?
a. Sell the position immediately and pay taxes at the short-term gains rate.
b. Hold onto the position for at least a year to enjoy the more-favorable capital-gains rate.
c. Sell a little at a time so that you can defer some taxes while still reducing the concentration risk of your portfolio.
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