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.
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