Portfolio Construction is like building a co llection of different things to make sure we don't lose all our money. We don't want to put all of our eggs in one basket because if something goes wrong with that one thing, we could lose everything. So, we try to pick a mix of things that will help us make money but won't all go bad at the same time.
One way we do this is by picking different types of things to invest in. Some things are risky and could make us a lot of money, but could also make us lose a lot of money. Other things are safer but might not make as much money. So, we try to pick a little bit of both to balance things out.
For example, we might choose to invest in stocks, which are like little pieces of ownership in a company. Stocks are considered risky because their prices can go up and down a lot depending on how the company is doing. But they can also make us a lot of money if the company does well. On the other hand, we might also choose to invest in bonds, which are like loans to companies or governments. Bonds are considered safer because they are more predictable and usually pay a fixed amount of interest. But they might not make us as much money as stocks.
Another way we balance risk and reward is by diversifying across different sectors of the economy. A sector is like a category of companies that do similar things. Some common sectors include healthcare, technology, construction, energy, and consumer goods. Sector diversification is very important because different sectors have different performances in different economic cycles. For example, during recessions, healthcare tends to be relatively resilient while tech companies often suffer. By investing in different sectors, we can spread our risk across different industries and reduce the possibility of being exposed to companies with the same financial performance during weak financial conditions.
Finally, we also diversify across different regions of the world. This is called Geographic Diversification. Political or geopolitical disruptions can cause the financial assets of specific regions to underperform their global counterparts. Also, each economy has its own economic risks, so investing in different countries can help reduce the risk of a portfolio. For example, if an investor invests only in the United States, they are exposed to only the risks of the US economy and political system. By investing in other countries, investors can spread the risk across different regions.
In recent years, a new type of asset has emerged called digital assets. Digital assets primarily consist of cryptocurrencies such as Bitcoin and Ethereum. These are considered assets with high-risk and high-reward potential. Investors are increasingly adding such alternative assets to their portfolios to increase their potential for achieving higher returns. It is crucial to highlight, however, that digital assets are extremely volatile and should only be considered as a tiny part of a well-diversified portfolio.
Diversification means investing in different things to reduce the risk of losing money but not everyone needs to invest the same way. It depends on how much risk you're okay with and what you want to get out of your investments.
Some people make two mistakes when they diversify. One mistake is when they invest in too many different things. This can make it hard to make good returns on their investments, and it can be expensive to manage their portfolio. The other mistake is when they invest in too few things because they think they'll make a lot of money that way. But that's very risky, and they might miss out on other good investment opportunities.
Finding the right balance between risk and return is crucial. That's different for everyone, but a good rule of thumb is to have 20 to 50 different investments in your portfolio. If you have less than 20, it's too risky. If you have more than 50, it's too hard to keep track of everything.
Determine where to invest your money to get the maximum return on it by using asset allocation. Making a recipe with your money is similar to that. Because every situation is distinct, every person will have a different recipe. Considering how much danger you're willing to take is a crucial step. While some people want to play it safe, others are fine with taking bigger risks.
One way to decide how to allocate your money is based on your age. If you're younger, you have more time to take risks and recover from any losses, so you might put more money into riskier things like stocks. If you're older and closer to retirement, you might want to play it safer and put more money into things like bonds and cash.
Another way to decide how to allocate your money is based on how much risk you're willing to take, regardless of your age. If you're okay with taking more risks, you might put more money into stocks and things like cryptocurrencies. If you prefer to play it safe, you might put more money into safer things like bonds and cash.
Finally, you can decide how to allocate your money based on when you need it. If you need your money soon, you should put it into things that are very safe and easy to get to, like cash. If you don't need your money for a while, you might put it into riskier things like stocks, which can grow a lot over time but can also be risky.
In general, asset allocation is different for everyone and depends on what you're comfortable with. But one way that works for many people is the age-based approach, where you take your age and subtract it from 100 to figure out how much to put in stocks versus safer things like bonds and cash.
When people have money, they often want to make it grow by investing it. But how can they know if their investment is doing well or not? That's where "returns" come in. Returns are like a report card for investments that show how much money the investment made or lost over a certain time period.
There are three ways to measure returns. The first is called "absolute returns," which is just the actual amount of money the investment made or lost. For example, if you invested $100 and made $7, your absolute return is 7%.
But sometimes it's not enough to just look at how much money an investment made. We also need to compare it to other similar investments to see if it did well or not. That's where "relative returns" come in. Relative returns measure how well the investment did compare to others. For example, if a similar investment made 10%, and yours made 7%, then your relative return is -3%. That means your investment didn't do as well as the others.
But there's one more thing to consider: Risk. Some investments are riskier than others, which means they have a higher chance of losing money. So it's not just about how much money investment made, but also how much risk was taken to make that money. This is when "risk-adjusted returns" come into play. Risk-adjusted returns look at both the returns and the risk involved in making those returns. This is a more advanced way to measure returns, but it gives a more accurate picture of how well an investment did compared to the risk taken.
The "Sharpe ratio" is a way to find out if an investment is good or not. It looks at how much money you could gain or lose (which is called "risk") and how much the investment's value goes up and down (which is called "volatility"). Then it calculates a number that tells you if you're making enough money for the amount of risk you're taking. It also compares this with how much money you could make if you just kept your money in a savings account. A higher Sharpe ratio means you get more return for the same amount of risk.
So, measuring returns is essential for investors to know how well their investments are doing. There are three ways to do this: absolute returns, relative returns, and risk-adjusted returns. Absolute returns just show how much money was made or lost, relative returns compare the investment to others, and risk-adjusted returns consider both the returns and the risk taken to make those returns.
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