Four Steps

THINK OF PORTFOLIO building as a four-step process. First, consider why you’re investing. That will give you a sense for your time horizon and hence how much risk you can take. Keep in mind that some goals have a harsh deadline, such as the day you make the house down payment, while other goals involve spending your savings over time, as happens with retirement.

From there, proceed to the second step: settling on your asset allocation, which is your portfolio’s basic mix of stocks, bonds and other investments. Stocks get all the media attention, but a significant minority of American families don’t have any stock market exposure. Your asset allocation will be driven heavily by your time horizon, though you will also want to consider other factors, such as your job security and how comfortable you are taking risk.

After you have settled on your asset allocation, it’s time for the third step: figuring out how you’ll diversify your stock market money, your bond market money and so on. This means deciding what percentage of your portfolio you want in, say, U.S. smaller-company stocks, foreign-government bonds and U.S. high-yield junk bonds.

Now, you can proceed to the fourth and final task: selecting investments to build your desired portfolio. You will likely want to favor mutual and exchange-traded funds, especially those that will allow you to capture the market’s performance at low cost.

Successful investing, however, isn’t just about knowing the basics. It’s also about attitude. To succeed as an investor, you need to avoid mental mistakes and approach the markets with the mindset of a seasoned investor—topics we touch on at the end of this chapter and also in the chapter devoted to humans.

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