Structuring Portfolios

For long-term investment success, it is essential that an investor creates and maintains a properly structured portfolio. A portfolio is generally structured at three levels.

First, the investor has to choose the broad asset classes (for example, stocks, bonds, etc.) in which to invest and decide how much of the portfolio to invest in each asset class. This is generally called the portfolio's asset allocation. Studies have shown that a portfolio's asset allocation has the largest impact on its long-term return.

Second, the investor has to choose within each asset class the categories of securities in which to invest. For stocks, the categories may be large-cap stocks, small-cap value stocks, and so on. For bonds, these may be short-term bonds, long-term bonds, foreign bonds, and so on. The investor then must decide what percentage of his allocation to each asset class he wants to allocate to each category within that class.

Finally, within each category of securities the investor has to choose specific securities and mutual finds and decide how much to invest in each of them. To make this decision, the investor will probably start with a select list of stocks or funds in each category and then do an allocation among them.

Although both financial theory and analysis of historical data provide some guideline for portfolio structuring, there is quite a bit of leeway in choosing the allocation at each level. There is no perfect answer, and even for the same person the "right" portfolio will change over the years as family circumstances change (for example, children go to and then finish college, the couple approaches retirement, and so forth). Although most people think that they should adjust their portfolios at least periodically in response to changing market outlook, market history shows that no one can reliably predict what the market will do in the future and which stocks will do better than the others over the years. Contrary to what most people believe, then, the structure and holdings of a portfolio should not be influenced much by anyone's views on the market outlook.

It is best to structure a portfolio systematically as described above and the best way to do so is by using a portfolio-structuring model. We will develop one such model in the modeling section.

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