Choosing investments for your portfolio is a task that requires thought. Even the easiest of investments, like index funds, require you to take a little time to consider the impact of their addition to your portfolio.
As you build your investment portfolio, one of the items to keep in mind is how an asset will fit your short-term and long-term financial needs.
What are Your Financial Goals?
Before you begin investing, you need to determine your financial goals. Consider what you want to accomplish with your money, and how your investment portfolio fits into the overall picture.
Do you have shorter-term goals, like sending your child to college in the next five years? Do you have a 30-year timeframe for your retirement portfolio? Think about what your assets should do on your behalf. The goals you have will determine the types of investments you include in your portfolio.
Evaluating an Asset for Your Portfolio
One of the widely accepted strategies for investing is the use of asset allocation. The idea behind asset allocation is to build a portfolio with investments from different asset classes. Stocks, bonds, cash, real estate, commodities and currencies are all examples of asset classes. Each asset class has its own degree of perceived risk and reward.
Asset classes with higher risk come with the potential for greater returns, while those assets considered safer may not even provide returns sufficient to overcome inflation. The key to asset allocation is trying to create a portfolio that offers you the growth you need to reach your goals, but balances that with a degree of safety so that you aren't completely devastated by market volatility.
Your asset allocation might change as you approach your goal. For instance, if you are saving for retirement, and you have a timeframe of 30 years, you are likely to start out by investing with riskier assets. You might be willing to put 80 percent of your portfolio in stocks (perhaps using index funds to limit some of the risk), 10 percent in bonds (a bond index fund might make sense), and the remaining 10 percent divided between real estate (perhaps using real estate investment trusts) and commodities (with the help of exchange-traded funds).
Because you are at the beginning of your journey, you have more time to make up for market downturns, and the potentially higher returns of your riskier assets make up for some of the volatility. As you approach your retirement, though, you might shift your asset allocation, selling some of your stocks, real estate and commodities and replacing them with more bonds, or even using cash. You'll still want to maintain some of stock assets, since you'll want some growth, but the goal changes to income and safety, rather than growth.
When evaluating an asset for inclusion in your portfolio, you need to see whether or not it meshes with your current assets. Do you need to sell something else in order to make room for the new asset? Do you need to shift your allocation to reflect your changing needs?
Don't add an asset just because someone gives you a hot tip. Really look at your goals. Are you trying to build income? Then you might need to add more dividend stocks and bonds to your portfolio. Are you attempting to speculate with "extra" money (that you can afford to lose) in the hopes of getting an investment bonus?
Think about what you are likely to gain – and what you could possibly lose – before you add an asset to your investment portfolio. With careful though, and attention to your goals, you can make decisions that are more likely to help you achieve your own version of financial success.
Miranda Marquit is a freelance financial journalist. She writes about beginning investing, low cost index funds and dividend stocks for a variety of financial websites. Her own blog is Planting Money.