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Course 501
Building a Portfolio, Part 1

Introduction

Up until this point, we have examined in detail the factors you should consider when investing in a single stock. Now we are moving into slightly different territory. In this course, we will cover what you need to think about when crafting a portfolio of stocks and some portfolio-building strategies you might consider--strategies practiced by some of Morningstar's favorite investors. The first step in building a portfolio of stocks is assessing your financial situation. A simple investment-policy statement can define your investment objectives and constraints. In this session, we'll cover how you can define your objectives.

Objective One: What Sort of Return Do You Need?

You should have an idea of what sort of return you are hoping for from your investments. That figure should be derived from whatever your return objective, or goal, is, whether that's investing for your own retirement or for your child's college education. Ask yourself: What is the purpose of my portfolio? To gauge the returns you can expect from your portfolio, you can examine historical returns and estimate expected returns among asset classes such as stocks, bonds, and cash. The catch, of course, is that while historical returns are known with certainty, expected returns are best estimates or guesses. To estimate expected returns, you must go through a process called scenario analysis. In this process, you look at different return outcomes of a portfolio and assign the probability of those outcomes occurring. For example, look at the rate of return that an asset class might earn during different economic conditions--such as booming, steady, or recessionary--and then assign the likelihood of those conditions occurring. This will give you an expected return for your portfolio on the basis of how much you invest in each asset class. Many software programs do scenario analysis for you. Since expected return is especially difficult to quantify for short time periods, it's helpful to have a long-term goal in mind when you're talking about a stocks-only portfolio.

Objective 2: How Much Risk Can You Stand?

Risk tolerance goes hand in hand with return objective. Even if you are new to investing, you have no doubt heard that you can lose money by investing in the financial markets. By coupling your return objective with an appropriate risk tolerance, you can establish a long-term set of guidelines for your portfolio. The amount of risk you are willing to tolerate should play an important role when you pick the individual investments for your portfolio. There is a trade-off between risk and return--the higher the risk, the greater the expected return on the portfolio. On the flip side, however, the potential for losses is greater with a risky portfolio. The lower the risk of a portfolio, the greater the chance of earning a lower rate of return, but the potential for losses is lower too. So if you have a long-term investment objective--say, retiring in 25 years--you can take on more risk than if your objective is just two or three years away.

Measuring Your Risk Tolerance

So how do you measure risk and determine your risk tolerance? There are numerous formulas that will calculate a quantifiable risk number. You may also be concerned with a few more general risks. These include: Losing money. The most basic risk is that you'll lose money when the price of the financial asset falls below the purchase price. When building a portfolio, look at losses in the context of the entire portfolio, not just at the loss that may occur in one investment. Venturing into unfamiliar instruments. This is the fear of the unknown. You may be uncomfortable investing in a company or financial asset whose products and services you've never heard of or seen before. Shunning familiar investments that you've lost money on. If you've previously lost money in an investment, you probably won't be inclined to reinvest money in that same investment. In this case, the psychological barrier usually outweighs the rational investment logic. Going against the crowd. This is the fear of investing in companies that have been beaten down for whatever reason. Most individuals like investing with the crowd and feel that there is less risk when purchasing popular investments. In fact, the opposite may be true. These are just a few of the ways to look at risk when attempting to gauge your individual risk tolerance. By carefully balancing your return objective with your risk tolerance, you will have designed a portfolio that fits your individual needs and financial circumstances.

Quiz 501
There is only one correct answer to each question.

1 I'm new to investing and want to build a portfolio of stocks. What's the first step I should take?
a. Buy the stocks people were talking about at a recent cocktail party.
b. Determine your return and risk objectives.
c. Throw darts at The Wall Street Journal and buy the stocks the darts land on.
2 I invested in a technology company that lost 50% of its value, and I decided to never invest in technology companies again. I fear:
a. The unknown.
b. Familiar investments that I've lost money on.
c. Going against the crowd.
3 Which best describes the relationship between return and risk?
a. The higher the risk, the greater the return potential and the potential for greater losses.
b. The lower the risk, the greater the return potential and the potential for lower losses.
c. There is no relationship between return and risk.
4 Which of the following best describes scenario analysis for estimating future returns?
a. Estimate the probable return for different asset classes under one economic condition and then multiply those returns by the percentage weight of each asset class. Add the outcomes for an estimated portfolio return.
b. Estimate expected returns for different asset classes in various economic conditions such as booming, stable, or recessionary. Multiply those returns by the percentage weight of each asset class. Add the outcomes for an estimated portfolio return.
c. Use historical returns of different asset classes as your expected future returns. Multiply those returns by the percentage weight of each asset class. Add the outcomes for an estimated portfolio return.
5 My child is three years old, and I am building a portfolio that will be the only means for her college education. How much risk can the portfolio tolerate?
a. Since you're saving for a known expense, your portfolio should have minimal risk.
b. This portfolio shouldn't include any risk since it is the only means for your child's education.
c. Since your time horizon is long term (at least 15 years), you can tolerate a fair amount of risk, which will enhance the long-term return potential.
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