An investment portfolio, and the underlying asset allocation which makes up the portfolio, is typically designed based upon attributes unique to the investor, such as risk tolerance and time horizon, as well as factors external to the investor. Such external factors include market conditions, macro and micro economic factors, individual security analysis, as well as a large variety of other factors, the details of which will not be discussed here. Here we will focus on two factors which are unique to each investor: the investor’s time horizon and the investor’s risk tolerance. By varying the amounts of stocks, bonds and other asset classes based upon these two factors a portfolio can be designed and managed to meet an investor’s goals and objectives.
Investments with greater returns typically have greater risks, and investments with lower returns typically have lower risks. An investor with a long time horizon can afford to suffer through market downturns; and for this reason could have a larger amount of risky, high return investments than an investor with a short time horizon. An investor with a short time horizon should have a higher concentration of lower return, lower risk investments than an investor with a longer time horizon.
An investor with a high risk tolerance can afford to hold a larger concentration of high risk, high return investments than an investor with a low risk tolerance. Such an investor will be less likely to become upset during a market decline and sell their investments. This is a critical aspect of portfolio design and construction, particularly for individual investors. An investor with a low risk tolerance would be more likely to become upset and sell risky investments during a market downturn, incurring a loss. Such an investor should therefore hold a larger concentration of lower risk, lower return investments, as such investments will be less likely to decline in value by significant amounts.