Creating a Reliable Investment Portfolio: 5 Strategies for Long-Term Investing

Movchan's Group

Jan 1, 2024

Creating an investment portfolio is one of the most important components of long-term investment strategies. In this article, we will explore different approaches to help create an investment portfolio capable of ensuring reliable and stable growth of investments. Whether you are an experienced investor or a beginner, these investment strategies will help you understand how to select assets for your portfolio, manage them effectively, and minimize risks.

How to Form an Investment Portfolio

In investing, a portfolio refers to a set of assets in which an investor invests their money. Assets can be both exchange-traded, such as stocks, bonds, currencies, and non-exchange-traded: physical real estate, precious metals, luxury items, or art.

For successful portfolio management in investing, it is important to consider the acceptable level of risk and goals. Therefore, before starting to build an investment portfolio, it is necessary to develop a long-term investment strategy and answer a number of questions:

1. What is my investment goal? It could be: saving for retirement, children's education, buying a home, creating a reserve fund, or achieving financial independence. Depending on the investment goals, the composition of assets in the investment portfolio will vary.
2. What risk am I willing to take? An investor's risk profile depends on their financial situation, experience, age, and personal preferences. Determining the acceptable level of risk will help choose an appropriate investment strategy in 2024 — conservative, moderate, or aggressive.
3. When might I need the money? The investment horizon affects the choice of assets and strategy. For long-term goals, such as retirement, more risky but potentially more profitable assets can be chosen. For short-term goals, such as buying a home in a few years, more stable and low-risk assets are preferable.

How to Choose Assets for a Portfolio

In the classical approach, the goal of creating a portfolio in investing is to maximize return considering risk. Its author is the scientist Harry Markowitz, considered the father of modern portfolio theory. In 1952, he published an article titled "Portfolio Selection," in which he proved that the volatility of a diversified investment portfolio is less than that of individual assets. Four decades later, he received the Nobel Prize in Economics for this discovery.

Today, the principles laid down by Markowitz, including the diversification of an investment portfolio by asset classes, are used by many investors when composing a portfolio. A classic is considered a 60/40 investment portfolio, which consists of 60% stocks and 40% bonds. In theory, such a portfolio should yield a positive return in any market conditions. However, in certain years, the portfolio value may decrease, but this happens rarely.

Long-term investments in stocks can yield high returns if companies are chosen wisely. There are several methods for selecting stocks for an investment portfolio: buying securities priced below their fair value, buying fast-growing companies, and acquiring companies with high dividends. To choose bonds for a portfolio, one must consider the issuer's credit and interest risks and the maturity period. More about stocks, bonds, and other instruments we discuss here.

An example of a portfolio for an investor focused on long-term growth includes stocks of large companies and government bonds. The investment portfolio should include those assets that fit the long-term investment strategy. Typically, three types of strategies are highlighted that help answer the question of how to choose assets for a portfolio:

• Conservative strategy. In an example of an investor's portfolio with such a strategy, the focus should be shifted in favor of instruments with a lower level of risk. These include, for example, bonds of developed countries with high ratings, bonds of the largest companies, or funds that invest in such instruments.
• Moderate strategy. In this case, the portfolio will include both reliable instruments, such as government bonds and bonds of large companies, as well as more risky but potentially more profitable assets, such as bonds from emerging markets, or funds that invest in such instruments.
• Aggressive strategy. In such a portfolio, a significant portion will be occupied by long-term investments in stocks.

The basis of portfolio investment theory is the idea that the higher the return on a financial instrument, the higher the level of risk, which is determined by price volatility or the size of a potential drawdown. These parameters are usually calculated based on historical data. However, past price dynamics do not necessarily indicate the same dynamics in the future. Therefore, the best investment strategies also use qualitative analysis of the financial condition of the issuing company, market situation, and more to assess risks.

Diversification of an Investment Portfolio: Risks to Avoid

Diversification is one of the most important components of strategies for creating an investment portfolio. It involves distributing investments among different asset classes to minimize risks and increase potential returns. Risk reduction occurs because instruments react differently to various types of risks.

Above, we discussed diversification by asset classes, namely the combination of long-term stocks and bonds in a portfolio. The second important question is how many stocks should be in a portfolio to be diversified. In 1970, scientists Lawrence Fisher and James H. Lorie calculated that if there are two stocks in a portfolio, the non-market risk of specific companies is reduced by 46%, if four — by 72%, if 8 — by 81%, 16 — by 93%, and if 32 — by 96%.

However, this does not mean that the more securities in a portfolio, the better. Forming a portfolio of 32 stocks will require twice the effort from an investor than a portfolio of 16, and will gain only 3 percentage points in risk. Moreover, it will require twice the effort and likely lose in quality. Billionaire financier and head of the Baupost Group hedge fund Seth Klarman believes that it is enough to limit to 10-15 securities.

However, not any set of fifteen securities can ensure the diversification of an investment portfolio. A good example is the bankruptcy of the American hedge fund LTCM in 1998, which invested in bonds of different countries (including Russia). When the Asian financial crisis erupted in 1997, investors began to sharply withdraw from emerging markets, and the value of bonds in LTCM's portfolio fell. The fund was finished off by the default on Russian bonds in 1998.

During the crisis, assets began to move in one direction. This is an example of market risk realization, i.e., the overall market decline. More about other types of risk we discussed here.

Founder of financial company M.J. Whitman & Co Marty Whitman suggests investors consider three types of investment portfolio diversification:

• By types of securities — that is, for example, including not only stocks but also bonds in the portfolio.
• By sectors — that is, investing in companies from different economic sectors: industry, technology, finance, and so on.
• By countries — in other words, investing in assets in different countries.

Diversification by Types of Securities

Another popular method in investments for beginners in 2024 is breakdown by types of securities. A few years ago, investors actively discussed the "death" of the traditional 60/40 portfolio. High inflation after the pandemic led to a rise in rates, which hit both stocks and bonds: in 2022, the 60/40 portfolio of American stocks and bonds fell by 17.5%. However, this is still better than the 20% drop in the S&P 500 index that year.

Markowitz himself suggested breaking down the portfolio by the principle of 50/50. Benjamin Graham, one of the proponents of long-term investments in stocks, in his now-classic book "The Intelligent Investor," also suggests investing in stocks and bonds with a ratio of 50/50 or 25/75, depending on the market situation. The share of long-term investments in stocks can be 25% if the investor considers their value overestimated, or 75% if a price drop increases their attractiveness.

Other asset classes, such as gold, can also reduce risks in the portfolio. More about other classic portfolios — in the text below.

Diversification by Sectors

Whitman also suggested investing no more than 25% of savings in securities of companies from one economic sector. Investors have plenty to choose from: the American market is divided into 11 sectors, including telecommunications, consumer staples, consumer discretionary, energy, finance, healthcare, industrials, information technology, materials, real estate, and utilities.

Relatively defensive, that is, less risky but also potentially less profitable, are the utilities and real estate sectors. The most rapidly growing is the IT sector, which is part of the best investment strategies for 2024.

Diversification by Countries

Many investors neglect country diversification of an investment portfolio, investing only in the US market — the largest best market. However, as demonstrated by scientists from Dalhousie University in Canada, from 1995 to 2021, country diversification proved to be a more effective tool for risk reduction than sector diversification. Studies with other timeframes, however, show that in some cases, investors benefit more from diversification by industries.

To diversify an investment portfolio, one can consider the weight of each country's stock market in the global MSCI index. The US accounts for about ⅔ of the index, and another approximately 9% is collectively for the UK and Japan. This means that a portfolio with a 10% share of China would already look risky.

Examples of Investor Portfolios

Modern portfolio theory laid the foundation for creating so-called all-weather portfolios in investing, which should show relatively high returns in any market conditions. The portfolio of Ray Dalio, founder of the world's largest hedge fund Bridgewater Associates, looks like this:

• 30% — stocks of large companies;
• 40% — long-term (with a maturity of more than 10 years) government bonds;
• 15% — medium-term bonds (with a maturity of 5 to 10 years);
• 7.5% — gold (a traditional defensive asset);
• 7.5% — other commodity exchange-traded assets: metals, agricultural products, energy resources, etc.

In addition, Dalio identified four modes of the world economy in which different assets work differently:

• inflation growth,
• inflation decline,
• economic growth,
• economic recession.

Another all-weather example of an investor's portfolio was proposed by financial consultant Harry Browne:

• 25% — American stocks, which will yield high returns during periods of economic growth;
• 25% — long-term US government bonds, which will provide returns during periods of deflation or economic recession;
• 25% — precious metals, such as gold, for protection against inflation and currency crises;
• 25% — cash or equivalents, such as money market funds. This part of the portfolio may be needed during a crisis if liquidity is urgently required.

There are also so-called balanced portfolios. A classic example is the same ratio of stocks and bonds 60/40. These 60% can include:

• 40% — large US companies;
• 10% — stocks of companies from markets outside the US;
• 10% — emerging market stocks.

In the 40% of bonds from the balanced portfolio example, you can include:

• 30% — US government bonds;
• 10% — corporate bonds with a high credit rating.
• There are other examples of balanced portfolios, particularly a more moderate one, with a stock-to-bond ratio of 50/50.

In the 50% of stocks, you can include:

• 30% — large US companies;
• 10% — stocks of companies from markets outside the US;
• 10% — emerging market stocks. And in the other 50% of the portfolio, select bonds:
• 35% — US government bonds;
• 10% — municipal bonds;
• 5% — bonds of companies from markets outside the US.

How to Manage an Investment Portfolio

Over time, the proportions of assets within a balanced portfolio will change due to changes in their value. For example, if in a 50/50 portfolio the value of stocks increased over the year, the stock-to-bond ratio in it might have changed to 70/30.

As a result, risks increased, and the portfolio ceased to be balanced. To fix this, it is necessary to restore the original asset proportions, i.e., perform rebalancing. Rebalancing is a long-term investment strategy that helps minimize risks. Its importance is confirmed by historical data.

There are different approaches to portfolio rebalancing:

• Time-based rebalancing implies that the stock-to-bond ratio is returned to the original at a certain time: every week, month, quarter, half-year, or year. The frequency of rebalancing slightly affects risk and return levels. That is, the fact of rebalancing is important, not its frequency, so when choosing, you can focus on commissions.
• Threshold-based rebalancing implies that the investor chooses the level of deviation of the stock portion in the portfolio at which rebalancing should be performed. For example, the investor decided that the maximum change is 10 percentage points. In this case, if in their original 50/50 portfolio the stock portion reaches 60%, rebalancing should be performed.

These approaches can be combined. For most diversified investment portfolios, annual or semi-annual rebalancing with a threshold value of 5% provides a reasonable balance between risk control and cost minimization for most investors.