Caution is key to a well-planned portfolio

The balanced view - rather than hectic risk-taking or attempts to beat the market - is the key to building up a profitable collection of investments. Be prepared to invest time and money, too, advises Clifford German

Building your own investment portfolio is a satisfying and, on past experience, profitable hobby, but it should not become an obsession. Most of the "day-traders" who deal in the hope of making quick profits out of short-term trends actually lose money once they have paid stamp duty and broker's charges on their deals.

Building your own investment portfolio is a satisfying and, on past experience, profitable hobby, but it should not become an obsession. Most of the "day-traders" who deal in the hope of making quick profits out of short-term trends actually lose money once they have paid stamp duty and broker's charges on their deals.

If you monitor trends and keep up with market sentiment on a regular basis, you may well be able to beat the market average by "tilting" the balance of your portfolio to anticipate shifts in fashion such as the boom in technology and dot.com stocks and buying and selling cyclical stocks at the right time. But market-beating is not an exact science: the economic cycle never repeats itself precisely.

The turning points can vary, and there is always the risk of unexpected events, such as rapid rises and falls in oil prices, the collapse of a regional currency, a local financial scandal or sudden ups and downs in international tension. Changes can also be quite abrupt, so that investors who miss the turn in sentiment by even a few days or weeks can be a long way behind the action by the time they have mobilised their resources.

To build a balanced portfolio that will genuinely maximise returns and minimise risk you will probably need a well-planned portfolio of around 30 individual investments, and that takes time and money to organise. The minimum you need to invest in a single asset should be at least £1,000 and probably more; otherwise brokers' minimum commission charges are liable to take too big a bite out of your profits every time you deal.

But there is a short cut to building a diversified portfolio - through managed or pooled funds, the generic name for investment trusts, unit trusts and open-ended investment companies. All three types employ professional managers to choose a range of assets to spread the risks for individual investors and hopefully to benefit from professional expertise.

Investment trusts are the oldest form of pooled investment, dating back to the 19th century. The money subscribed by investors in a new trust is used to buy a portfolio of investments that are expected to pay dividends and increase in value. Once established the shares in the trust can be bought and sold like any other quoted company.

Investment trust shares can be worth more than the combined market value of the assets in which they are invested, but usually their shares stand at a discount to the value of the assets. The current premium or discount is an important piece of information published daily in the financial pages. A discount allows new investors to buy assets on the cheap, and trusts that fall to too big a discount are liable to takeover bids by other trusts to unlock the extra value. Alternatively the managers themselves may decide to merge poor performing trusts or turn them into unit trusts.

Unit trusts have been around for a mere 70 years but there is now a vast choice of different managers and different trusts. They range from tracker funds, designed to move in line with one or other of the main market indices and general funds designed to achieve either high income or capital growth or a combination of the two, to a whole range of specialist funds.

These invest in selected markets such as technology, resources or smaller companies, or in selected markets such as the United States, Europe, Japan or emerging markets. Specialist funds tend to be more volatile than tracker and general funds and they often levy higher charges. Unlike investment trust managers, unit trust managers must create new units and reinvest all new money they are offered, and sell investments and cancel units to meet withdrawals, so the units are always worth the same as the assets in which they are invested. Unit trust managers cover their costs by quoting two prices for their units, a price at which they sell and a price at which they will buy back, with a "spread" of up to 5 per cent between them. Annual management charges can be as low as 1 per cent or as high as 2.5 per cent depending on how many expensive fund managers are needed to manage the portfolio.

Open-ended investment companies only quote a single price but they will tend to levy an initial charge and sometimes an exit charge for investors who want their money back, in addition to annual management charges.

Although all managed funds make charges for their services, and these can swallow up most of the dividend income, they do have several advantages apart from spreading the risk of investing direct in shares of individual companies. Fund managers increasingly allow investors to switch money from one type of fund to another within the same management group, and they also encourage small investors to make regular investments that will build up into a sizeable sum over time. This allows investors in managed funds to gain from two important benefits. The same monthly investment actually buys more assets when share prices are low. Dividends can also be reinvested in accumulator funds to take advantage of the "miracle" of compound growth rates over long periods of time.

Managed funds are also ideal investments for small investors who want to take advantage of the opportunity to shelter their investments inside an Individual Savings Account or ISA, because the managers will collect the tax-free dividends and do all the necessary paperwork. From April 2004, ISAs invested in shares will no longer be entitled to reclaim tax on dividends but the opportunity for tax-free capital gains could be worth more in the long run. Managed investment funds are however only as good as the skills of the investment managers, and they frequently under-perform the markets in which they invest.

Investors should therefore take as much care in selecting the management group and the kind of fund in which they invest as they do in choosing individual shares. The same principles apply.

Spread your risks by investing in a managed fund but keep an eye on the performance of your fund relative to the competition. Last year's winners may not necessarily be next year's. They may have been lucky, or have specialised in the right sector of the market. If you feel the time has come to rebalance your portfolio or take some of your profits, by all means do so. Although the FTSE 100 index fell 10 per cent last year that was only the third time since the index was set up in 1984, the others being 1990 and 1994.

(Next time we will look at portfolios of three contrasting types of investor - yuppies who want to maintain their post-career lifestyles, couples approaching retirement who want to secure a comfortable old age, and employees of companies that don't provide a company pension.)

* Clifford German is a joint author with Arun Abey and Ean Higgins of Fortune Strategy, published by Financial Times Prentice Hall