What is an investment process?
About this lesson
In this video, you will learn what an investment process is.
Building a portfolio, step by step
A portfolio is your collection of investments. Building one follows a few steps.
1. Set objectives and constraints
Start with what you’re investing for and what limits you face:
- Return requirement: what you need the money to earn.
- Risk tolerance: how much short-term loss you can accept.
- Time horizon: when you’ll need the money.
- Constraints: liquidity needs, taxes, rules and personal preferences.
2. Asset allocation
Decide how to split the money between the broad asset classes: stocks, bonds, cash and others such as real estate. This is the “top-down” decision, and it drives most of a portfolio’s risk and return.
3. Security selection
Within each asset class, choose the individual investments: which stocks, which bonds, or which funds. Security analysis looks for securities that may be mispriced.
4. Monitor and rebalance
Markets move, so the portfolio drifts away from the plan. Review it regularly, measure its performance, and rebalance back to the target allocation when needed.
Top-down vs bottom-up
- Top-down: start with asset allocation, then pick securities within each class.
- Bottom-up: start by finding attractive individual securities, and let the overall mix follow.
Passive vs active
- Passive: hold well-diversified portfolios, such as index funds, without trying to find mispriced securities.
- Active: try to beat the market through security selection or market timing.