How to create an investment Portfolio based on volatility

The ability to diversify risk  in portfolios, will give you an edge over the market. Portfolios are basically a group of investments managed by an investor with the intention to reduce risk while maximizing returns.

Opening random investments in different sectors can be called a portfolio but it does not necessarily reduce risk or maximize returns. In this post we are going to discuss how we can create a group of investment based on the volatility and returns of an investment. In a later post we will address the diversification based on regions and sectors.

Investments are classified into many types but only those under money market and capital market  will be addressed here.

Money Market Investments:

These investments are often traded within a year. They have low interest rates thus yield low returns. These should not discourage you however they are great investment if you are looking to get great returns within a year. Great money market investments can yield a return of 7-10% within a year.  Examples include Treasury bills, fixed deposits, Certificates of Deposit, Commercial Deposits, Bankers Acceptances.

So how do we integrate this into our portfolio?

These investment instruments are what we are going to use to stabilize our portfolio. The low risk they carry will serve as a hedge (a protection against loss) in the portfolio. The returns from these investments also tend to appreciate in value in times of economic recession thus making them a sound investment choice when the stock markets are performing poorly.

Capital Market Investments:

These investments comprise of long term debt and equity backed investment instruments (stocks related instruments). They are more volatile and offer more returns to investors who are looking to invest long term. Examples, stocks, preference-stocks, ETFs, Bonds.

Role in our portfolio

These instruments are the investments will be looking to grow our portfolio rapidly. They are riskier hence they have to occupy a smaller percentage in the portfolio.

Portfolio Creation

As mentioned earlier the objective of creating a portfolio is to diversify the investments, mitigate risks and plan our cash flows(income stream) as we may be making withdrawals as times passes by.

Step 1: Shortlist investments in the money and capital market

Step 2: Depending on your risk appetite allocate funds to the various markets. Younger individuals are usually expected to take more risks while older individuals are expected to take less risks. Here are the suggestions for funds allocation to these markets.

	Risk Averse Investor	Moderate Investor	Aggressive Investor
Money market	80%	60%	40%
Capital Market	20%	40%	60%
	100%	100%	100%

Step 3: Systematically add to these investments so that they are always maintain their ratio. This is not a must but as you make more investments you must look at the market that needs to be invested in to ensure the ratio is maintained.

NOTE:  if you are to trade Forex you will have to categorize it under the capital market as it is a risky investment. A general rule is to always allocate less fund to riskier investments so the table for a portfolio of money, capital market and Forex will be as shown below.

	Risk Averse Investor	Moderate Investor	Aggressive Investor
Money market	80%	60%	40%
Capital Market	15%	30%	40%
Forex Market	5%	10%	20%
	100%	100%	100%