5 Essentials for Building a Profitable Portfolio

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For many people, investing is the most complicated and intimidating aspect of managing money. But it doesn't have to be. Here are some of the essentials for building a successful investment portfolio.

1. Know What You're Investing For

Investing is best done with a purpose in mind. Investing for a child's future college costs is not the same as investing for your retirement. You would use different investment vehicles — a 529-plan account or Coverdell Education Savings Account for college, and an IRA or 401K for retirement.

2. Know Your Time Frame

Investing is for goals you want to accomplish in five or more years. Anything shorter than that and you can't afford to take much, if any, risk, so you would be best served by a savings account.

Still, a "five or more years" time horizon contains a wide range of options. Someone planning to retire in 10 years should invest quite differently than someone planning to retire in 30 years. The first person can't afford to take as much risk as the second person. By the same token, the second person can't afford the risk of playing it too safe.

3. Know Your Temperament

This has to do with how well you sleep at night when the stock market is in free fall. Vanguard has a decent free assessment that combines your investment time frame with your temperament to suggest an optimal asset allocation — that is, what percentage of your portfolio you should allocate to stocks and what percentage to bonds (or stock, or bond-based mutual funds).

4. Know How to Choose Specific Investments

If investing is the most complicated and intimidating aspect of managing money, choosing specific investments is the most complicated and intimidating aspect of investing. Very few people have the wherewithal to do this on their own. It's helpful to acknowledge that. As Clint Eastwood's Dirty Harry character noted, "A man's got to know his limitations." Of course, the same is true for women!

There's just too much to know. There are thousands of different investments to choose from. And it can be crazy confusing (and dangerous) to make these decisions based on the all-too-common articles about "Last Year's Best-Performing Mutual Funds" or "Where to Invest to Take Advantage of Advances in Wind Power."

The crucial decision you need to make is not so much about which investments to choose; it's about which investment process to use. Here are three options.

Go With a Target-Date Fund

The simplicity of such funds has made them tremendously popular. Most of the big mutual fund companies offer them. You just choose the fund with the year closest to the year of your intended retirement as part of its name (Fidelity Freedom 2050, for example). The fund is designed with what the fund company believes is the ideal asset allocation for someone with that retirement date in mind, and it even changes the allocation as you get closer to that target date, becoming increasingly conservative. It's a very simple process, but all target-date funds are not alike. So, be informed.

Go With an Investment Adviser

He or she will get to know you and your goals and then tailor an investment strategy to you. Along the way, you will typically pay 1% of the amount of money you have the adviser manage for you each year. Also, advisers usually won't work with anyone with less than $100,000 to manage. If you go this route, ask friends for referrals and opt for a fee-based adviser (as opposed to one compensated by commissions) who works as a "fiduciary."

Go With an Investment Newsletter

Whereas an investment adviser works with clients one-on-one, an investment newsletter works with investors on a one-on-several thousand (or however many subscribers they have) basis. There are hundreds of investment newsletters, each with their own investment strategies. Subscribers gain access to the strategies along with the specific investment recommendations needed in order to implement the strategies. Subscription costs range from less than $200 per year to over $1,000 per year.

5. Know Some Market History

One of the biggest threats to your success as an investor can be seen in the mirror. When the market falls, it's easy to give in to fear and sell. When the market is booming, it's easy to give in to greed, and invest too aggressively.

Far better to understand that the market cycles between bull markets and bear markets (growing markets and declining markets). Even within a specific year, there will be ups and downs.

That's why it's so important to have a trusted investment selection process. With a good process in place, you should have some sense as to how your portfolio is likely to perform under a variety of market situations and you should be content to stay with it in good times and bad.