What is a portfolio?
A portfolio is a collection of financial assets, such as stocks/shares, savings accounts, property, bonds and other investments. A portfolio is used to do two things:
- Minimise risk; and
- Maximise returns
The saying, 'don't put all your eggs in one basket' refers to the idea that a well-managed portfolio should have diversification benefits, thereby lowering risk. Academics have debated that there are two broad types of risk.
The first type of risk is specific risk.
For example, if an investor puts 30% of her share portfolio in Gold Production Company Ltd shares and the gold price fell 50%, the other 70% of her portfolio (assuming she was not invested in other gold companies) should not face the same risk.
The second type of risk is called market risk.
Typically, this risk cannot be entirely reduced because it affects everything. In our example, if every share on the sharemarket fell 50%, chances are, the value of all the investor's shares might be affected. This risk can affect the entire market.
Everyone's tolerance for risk is different. But a well-crafted portfolio of assets should maximise the portfolio's return for a given level of risk.
For example, a young person with many years until retirement might have a high-risk tolerance and, therefore, invest more in risky assets like shares and property. An older person with a lower risk tolerance might invest more in government bonds and term deposits, which are often considered low risk.
Test Your Knowledge
(King) Joffrey inherits his parent's money at a young age and invests 80% of his portfolio in physical gold bars and 20% in Gold Company Ltd shares. Joffrey's risk tolerance is most likely:
Gold (a type of commodity) and shares are considered higher-risk investments. Not only that, Joffrey's portfolio is highly concentrated (making it even riskier) to just one investment theme (gold). In addition, no-one likes Joffrey.
Tyrion uses all his money to buy property. He buys two wineries, both specialising in red wine. Unfortunately, a few episodes later, red wine is proven to stunt growth and his properties are left virtually worthless. Tyrion failed to consider the:
By buying two of the same wineries, Tyrion's portfolio was highly exposed to the same type of risk: specific risk. This risk could have been reduced if he diversified. For example, he could have bought one winery specialising in white wine.
Khaleesi invests in 50% in shares, 25% in property, 20% in Zimbabwean Dollars (high risk) and 5% in cash. Jon invests 30% in blue chip shares, 30% in Australian government bonds (considered lower risk) and 40% in cash. Who has the best portfolio?
Khaleesi appears to have a higher-risk portfolio than Jon. But her tolerance for risk might be higher than Jon's, so there is no way to know who has the best portfolio. What's important is maximising the return for a given level of risk.
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