What comes to mind when you think about portfolio investment? When you hear the word “portfolio”, you may think of an artist’s portfolio. Both artists and investors collect things of value in their portfolios. In the case of an artist, they may keep their collection of sketches, paintings, or photographs together in a large folder.
On the other hand, an investor might not have a physical folder in which they keep their investments, but they collect financial instruments in a similar way. Investors collect different types of securities (bonds, commodities, real estate, art, stocks, etc.) together in their investment portfolio.
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So, as you might have guessed, portfolio investment refers to the process of purchasing certain passively-managed securities in order to earn an ROI (or return on investment) on them over time. But what exactly are “passively-managed securities” and what do they mean for your financial future? How do you manage your portfolio investments wisely?
Passively-managed vs. actively-managed securities
Imagine you’re in an endless race across the open ocean. Every fiscal quarter, you have a new point you’re trying to navigate to before your competitors.
Some of your competitors are passively-managed sailboats that have no captain and which follow the current (or, in this metaphor, the general market index). The ocean current and wind— or market fluctuations — guide their progress. When the current guides them towards their destination quickly, they experience gains. The same happens with passively-managed funds that follow the market index.
Imagine an investor with passively-managed investments that track, for example, the Dow Jones. They generally know that when the Dow Jones performs well, their investment does, too. If the market rose 5% in a single day and dropped 1% on the next, investors of passively-managed funds that track the Dow know that their investments have probably proportionally increased and decreased in value.
Like a little sailboat on the open ocean drifting with the current, the value of a passively-managed fund generally fluctuates with a stock market index.
On the other hand, some investors prefer a more active role in their investments. In our metaphor, these investors are more like motor-powered boats manned by a captain. The captain uses the motor (or their investment knowledge and data points) to try to beat the tide to reach their destination more quickly. Some actively-managed investment funds outperform the market index and investors receive massive returns.
The idea of hiring someone to actively manage your investment vessel might sound like an attractive idea. However, historically, the majority of these powerboats aren’t able to navigate effectively, and most end up doing worse than the market index. Portfolio investments generally outperform actively-managed investments.
Another factor to consider when choosing between portfolio investments and actively-managed investments is that passively-managed funds charge lower management fees than their actively-managed counterparts.
Popular lower-risk portfolio investments often include passively-managed ETFs and mutual funds, which are generally considered to be more stable over time because of their level of diversification (although there are actively-managed, riskier versions of these financial investments, too).
How can you manage your portfolio investments wisely?
An important part of managing portfolio investments wisely is related to how you initially select your investments. Remember that, like an artist’s portfolio, an investment portfolio is made up of different components. How you determine those components should depend upon your risk tolerance and timeline. Even amongst passively-managed investment options, the level of risk varies.
Risk tolerance refers to how much money you would feel comfortable losing on an investment before selling it. An individual’s risk tolerance is often related to their age, income, investment goals, and the portion of their budget that they dedicate to investing.
Your investment timeline refers to how long you have before you want to reach a particular investment goal. For example, a young professional might have greater risk tolerance because of a longer timeline — the short term volatility probably won’t affect their 30 year investment goals.
However, a person who is nearing retirement might prefer to invest in more stable securities (like bonds) because they involve very little volatility, and their money will be protected. Since they don’t have as much time to recover from drops related to normal market volatility, they might steer clear of certain types of investments.
The bottom line
When you select your portfolio investments, it’s important to be honest about your risk tolerance and investment timeline. These factors can help you select investments to help you meet your goals.
To learn more about the different types of financial instruments, check out the rest of our Academy education library.