Making the Most of Your Investment Portfolio: Diversification Is King

George's best stock market advice to you is to make sure you are diversified. How to use asset allocation as a critical part of any prudent portfolio management strategy. Stocks are facing some upside resistance at this juncture. Blue-chip companies continue to lead the way this year, with small-cap and technology companies trailing.

My best stock market advice to you is to make sure you are diversified. You need to add small-cap stocks in an effort to increase the expected return of your portfolio.

I would like to discuss the concept of asset allocation as a critical part of any prudent portfolio management strategy.

Asset allocation refers to the asset mix of your portfolio, which is divided into the three major asset classes: cash; fixed income; and equities (stocks).

As the macro and micro factors change, as well as your investment objectives, you should rebalance your asset mix accordingly to the new conditions.

In general, without getting too theoretical, the risk and expected return of an investment rises as you move along from cash to fixed income to equities. The higher the risk assumed, the higher the expected rate of return, albeit this is not always the case in reality. For instance, adding penny stocks and micro-cap stocks could add to your total return.

The relationship between risk and return should be used as a guideline.

The proportion of each asset class within your portfolio is dependent on your individual risk profile. For instance, the more risk-adverse investors and people who are close to retirement may want a higher mix of fixed income/cash and to steer clear of too much equity. On the other hand, risk-tolerant investors and those investors who are young may want to take a more aggressive approach and maintain a higher mix of equities in conjunction with less fixed income/cash.

A general rule for asset allocation is that the weighting of the fixed income portion as a percentage of your total portfolio should approximate your age.

Let’s say you are 25 years old. The basic guideline tells us that you should have about 25% of your assets in fixed income and up to 75% in equities. And, on the other end of the spectrum, a 50-year-old entering the final phase of his or her working life should have a conservative 50% weighting in fixed income securities. And, of course, a person at the retirement age of 65 should have a minimum of 65% in fixed income.

Keep in mind that this rule should only be used as a guideline and is not meant to be conclusive.

The aim of prudent asset allocation is to achieve the highest rate of return given the risk.

The most basic tenant of investing is to understand how to create an appropriate blend of equity, fixed income, and cash.

To determine your risk profile, you should first understand your investment personality.

Investors range from the ultra-conservative investor who wants to sleep at night to the highly aggressive speculator who thinks of the stock market as a roll of the dice. It’s crucial that you stay within your risk element if you are very conservative. For example, if you get jittery when the stock market gyrates, you may want to focus on fixed income and less on stocks; otherwise, you’ll be reaching for that bottle of “Prozac” a bit too often.

Asset allocation is often dependent on your age, but in reality, understanding each person’s risk profile is also very important. The only rule that generally applies is that the older you get the less exposure to equities and speculative issues you want, as you don’t want to risk your life savings for a hot tip.

Remember: Bulls make money; Bears make money; Pigs get slaughtered! Translation: Don’t get too greedy and live within your risk profile.