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Course 101
Steps to a Suitable Portfolio

Introduction

There's more to successful portfolio building than picking good investments.

Putting together a portfolio of securities is like building a home. Even if a house is filled with beautiful rooms that may not be enough: All those rooms need to work together to form a pleasing and useful whole. Investment portfolios are the same way.

This track of the Investing Classroom will show you how to design a successful portfolio of investments that work together to help you reach your goals. In this course, we'll introduce the five essential steps to tailoring your portfolio and keeping it in good shape. We'll expand on these steps in subsequent courses.

Create a Blueprint

Just as building a home begins with a blueprint, you need a pattern for your portfolio. The blueprint tells the builder to build a structure of a particular size and shape, with specific features, to suit the needs of its future owners. Similarly, your portfolio should suit your needs and specifications.

The best starting point when creating your portfolio blueprint is to focus on your investing goal. Maybe you're investing for retirement, for your child's education, or for a vacation home. We'll cover goals at length in Portfolio 102: Determining Your Goals and What They'll Cost.

Whatever your goal, it gives you vital information. It tells you how long you'll be investing (your time horizon), and how much of your investment you can put at risk. The closer your goal or the less you can afford to lose, the more you should focus on preserving what you've made rather than on generating additional gains.

How much should you put into cash, bonds, and various types of stocks? One rule of thumb is to use your age as a guide. For instance, if you're 33 years old, put 33% of your portfolio into cash and bonds and the rest into stocks.

Some investors might find that figure conservative, though. Others might find that it's too aggressive for their particular goal. Such rules are like buying a home without taking a tour inside. Sure, it looks good from the outside, but does it really suit you and the way you live? Maybe not. We'll show you how to determine what cash/bond/stock mix is right for you in Portfolio 105: Determining Your Asset Mix.

Discover What You Already Own

Maybe you can name all of your stocks and mutual funds off the top of your head and detail how each one performed last week. Good for you. But can you explain how they work together? Which are your core investments? Are you diversified? Do you have a lot of overlap? You must be able to answer those questions before you can see how (or even if) your portfolio fits your pattern.

To figure out exactly what you own, you could buy a financial calculator or investing spreadsheet, haul out the latest shareholder reports for your funds and account statements for your stocks, and calculate how much you have in cash, bonds, and various types of stocks. What a job! No wonder people don't know what's in their portfolios.

Use Morningstar's Instant X-Ray instead. Simply enter the tickers of all of your investments and how much you have invested in each, either in dollar or percentage terms. Then click "Show Instant X-Ray."

You'll discover your portfolio's asset mix, style-box breakdown, sector weightings, regional exposure, and much more. Then, for ongoing monitoring, just click to save your Instant X-Ray holdings as a Portfolio on Morningstar.com.

Make Your Portfolio Fit Your Blueprint

Now that you know what you have, it's time to find out whether your current portfolio fits your blueprint.

Begin by checking your portfolio's asset allocation. If that doesn't match the asset allocation you laid out in your blueprint, shift assets among funds and stocks to tailor the mix. If your investments are in taxable accounts, however, you might not want to sell any of them--you may pay commissions to trade out of them, and you may also owe taxes if your funds or stocks have gained in value since you originally purchased them. We'll talk about sell strategies in Portfolio 304: Strategies for Selling.

Next, weed out redundant investments. If you have three large-cap growth funds, for example, they probably aren't all equally good. Refer to Morningstar.com's Fund Reports to see which fund has the lowest expenses and longest-tenured fund manager, as well as a strong long-term risk/reward profile. Morningstar.com Premium Members can also read the Morningstar Analysis for insight into the funds' strengths and weaknesses.

Be sure that your portfolio includes core holdings, those investments on which you're relying most to help you meet your goals. Core investments should be the biggest part of your portfolio. We'll discuss how to choose them in Portfolio 106: Core vs. Noncore Investments.

Finally, fill any portfolio holes, such as a lack of value or foreign exposure, with new investments.

Schedule a Time to Rebalance

By following the first three steps, you've crafted a portfolio that you can live with. You'll want to make sure that it continues to fit your goals and needs, though. That requires occasionally rebalancing, or restoring the original blueprint. We'll cover the ins and outs of this in course 305: Rebalancing Your Portfolio.

Stocks often gain more than bonds or cash. Over long periods of time, stocks will probably take up more of your portfolio than they did in your original blueprint. Because stocks are riskier investments than bonds, your portfolio is becoming riskier as your stock position rises. That's why it's important to rebalance and restore your portfolio to its original pattern.

Similarly, not all stocks do well at the same time. Maybe your value stocks are outpacing your growth investments. If you don't restore your portfolio's original balance between the two styles, your investment success will become increasingly dependent on your value investments.

When you rebalance, keep your goal in mind. As you get closer to needing the money you've invested, the pattern you originally drew should change. Your portfolio should become more conservative as you approach your goal.

Monitor Your Investments

In addition to rebalancing your portfolio, you'll want to keep tabs on your individual investments. You need to make sure they're still filling their original roles in your portfolio.

Let's say you're monitoring your mutual funds. What types of things should you look for? Make sure your funds stay in the same Morningstar category; if a fund's style has changed dramatically, the fund may no longer meet your needs. Examine the fund's category rating--is it still competitive? Watch out for manager changes, too.

With stocks, you'll want to keep tabs on price, and where that price is relative to the sell target you've established. Changes at the top matter, too--new management can mean new strategy. Profitability, financial health, and growth prospects all matter, too.

We'll discuss these and other portfolio-monitoring issues at length in Portfolio 301 and 302.

Quiz 101
There is only one correct answer to each question.

1 A successful portfolio:
a. Need only contain good individual investments
b. Is the same for every investor
c. Should contain investments that work together to help you reach your goals
2 What vital information does your goal give you?
a. How long you'll be investing
b. How much money you can risk
c. Both A and B
3 A 40-year-old should put how much money in stocks?
a. The amount is a matter of personal preference, based on the investor's goal for the money
b. 40% in stocks
c. 60% in stocks
4 When figuring out whether your current portfolio matches your pattern, which question should you NOT ask?
a. What are my core investments?
b. How did my individual investments do last week?
c. Do I have a lot of overlap among my investments?
5 When it's time to rebalance your portfolio, which is the most likely to happen?
a. You'll probably have to increase your stock position and decrease your cash/bond position.
b. You'll probably have to increase your cash/bond position and decrease your stock position.
c. Nothing--rebalancing is for sissies.
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