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A beginners’ guide to building an investment portfolio

A beginners’ guide to building an investment portfolio

 

When constructing an investment portfolio – whether using ETFs or not – those new to investing should begin with a few simple questions:

 

  • What’s your investment goal? For example: to fund your retirement, or a future property purchase, or to put money away for a rainy day?
  • How long will you invest for?
  • How much risk can you handle?
  • How much risk must you take to meet your goal?

Once you’ve plotted out your objectives and risk capacity it’s time to think about which portfolio strategy best matches your needs and personal approach to investing.

Thankfully this doesn’t have to be a complicated decision. A few strategies have come to dominate the investing landscape because they are effective, simple to manage and don’t require you to juggle complex financial models and data.

The three main portfolio strategies worth knowing about are:

1.Buy and Hold

2.Core-Satellite

3. Trend following

The differences between them centre on how much value you believe you can add by actively managing your portfolio.

Buy and Hold is the simplest strategy that relies on a willingness to stick with the same investments through thick and thin.

Core-Satellite is built on diversified equities and bonds centre but allows for active forays into more specialised markets (the satellites) that may provide higher returns.

Trend following uses established ‘buying signals’ or data-driven rules to determine whether you should buy or sell the market at any given time. It’s a highly active strategy and the very definition of market-timing.

Other strategies exist but are not generally suitable for DIY investors because they demand expensive, high-quality financial data and computing firepower. The Value at Risk (VAR) method is a good example of an investing strategy with such high barriers to entry.

All the same, the flexibility of ETFs enables you to find the place on the strategy spectrum where you are most comfortable: from rigorously passive to highly active and anywhere in between. Let’s look at each of the main strategies, in turn, to see which is your best fit.

 

The Buy and Hold portfolio strategy

 

You choose an ETF portfolio that’s diversified across the main asset classes. Then you stick with it no matter what. New money is invested into your original ETF holdings and you don’t sell except for the occasional rebalancing move. All dividends and interest are reinvested into the same positions. It sounds too simple to be effective, right? Wrong! Buy and hold gets good results over time as you benefit from low costs, pound-cost averaging and the magic of compound interest.

 

Why Buy and Hold works

 

Check out our quick and easy guide to the best strategy for long-term investors.

But Buy and Hold does have one drawback: the lack of flexibility. You must have iron discipline to pull off a buy and hold strategy. When the markets are down, you ignore them. When a new asset class or niche comes along, you forget about it. Like eating your five-a-day, buy and hold is simple and effective in theory but hard to stick to in practice. If you like to keep things simple, don’t want to spend much time on your investments and have plenty of staying power then consider buy and hold.

justETF tip: We offer a wide selection of different world portfolio strategies that can be used as a template for buy and hold. With just a few ETFs, you can pick a cost-effective and highly diversified portfolio quickly and easily.

 

Core-Satellite as a portfolio strategy

 

Core-satellite is a best-of-both strategy that builds an active layer onto a passive base. It mostly consists of a rock solid core of equities and bonds.

This element is constructed like a Buy and Hold strategy and accounts for as much as 80% of your portfolio. You pick your core from the most broadly diversified ETFs which can include sustainability choices.

Your satellites then focus on the opportunities available in more interesting market niches. These choices hold the promise of higher expected returns, or protection in certain economic conditions, or enable you to take a concentrated position in an up-and-coming market e.g. robotics or cryptocurrency.

If you enjoy taking an active role in your investments, but don’t want to deviate too far from the mainstream, then a Core-Satellite ETF strategy is the perfect way to engage your tactical brain.

 

The Core-Satellite strategy with ETFs

 

Learn how to expand a Buy and Hold portfolio by exploiting the opportunities in exotic markets.

justETF tip: Our portfolio monitoring service helps you keep tabs on your Core-Satellite strategy and compare your performance against a Buy and Hold sample portfolio.

 

The trend following portfolio strategy

 

Trend following is a strategy that maintains you can outperform the market over time by using trading signals to predict when you should buy and sell.

For example, some trend followers use a signal like the 200-day moving average price of an index. If the current level of the index is above the 200-day moving average then you buy more of the index (e.g. the FTSE 100 or S&P 500). The theory is that when the index is above this level then the rising market momentum will continue and you can bag excess profits.

If the index price falls below the 200-day moving average then you sell out of equities and into a safer asset such as cash. Again, the idea is that a falling trend price will persist and the selling signal is your cue to avoid the market fall.

While DIY investors use simple rules such as the moving average, professionals (the so-called ‘quants’) use sophisticated algorithms and market models to capture returns from a wide variety of trends across many different markets.

Either way, the idea is to use established rules to manage your market timing rather than relying on gut instinct or forecasts.

There’s evidence that trend following works over the long term but you have to be able to handle many false trading signals in the short term. That can leave you out of the market at the wrong time and lead to many years of underperformance.

There’s also the risk that your trading rules could stop working full-stop. The sum of which means that trend following is not only mentally taxing but it requires significant courage to hold on during the years in which it fails to deliver.

 

Combining portfolio strategies

 

Naturally many investors like to mix and match ideas to create their own bespoke strategy. For example, it’s possible to:

  • Develop a Core-Satellite portfolio by branching out from a Buy and Hold portfolio.
  • Switch between satellite holdings using your preferred trend following rule.
  • Layer a signal model on top of Buy and Hold so you can switch some equities into cash under extreme circumstances.
Buy and Hold is usually best

 

Buy and Hold is the most straightforward choice for DIY investors. It’s simple, effective and endorsed by investing luminaries like Warren Buffett and John Bogle. What’s more, you can easily build your own broadly diversified portfolio with our ETF strategy builder.

From there, you can expand into a Core-Satellite or trend following strategy if you become convinced of their merits and upgrade your expertise. Naturally, such decisions are not to be taken lightly. More complicated strategies require more intensive management and research while your performance must also overcome higher cost and tax hurdles. If you do adopt a new strategy then make sure you measure its effectiveness versus the Buy and Hold baseline.

In the meantime, here’s a quick pro/con comparison of the various portfolio strategies:

 

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