The S&P 500 saw its five-day winning streak come to an end on Wednesday, but the index did manage to trade at an intraday high of 1,399.42. I sense that 1,400 will be tested, but it will likely be a tough barrier to beat. At the start of the year, I thought a 1,400 target for the S&P 500 could materialize if everything panned out and there were no surprises in Greece and the eurozone. So here we are about 11 weeks into the year, and the S&P 500 is up nearly 11%.
With some market uncertainty obviously present, a key investment strategy for any investor is 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, so should your investment strategy. You should rebalance your asset mix according to the new conditions.
Without going into portfolio theory, the risk and expected return of an investment increases as you move along the risk spectrum from cash to fixed income to equities. The more risk assumed, the higher the expected rate of return, albeit this is not always the case in reality.
The relationship between risk and return should be used as a guideline in your investment strategy.
The proportion of each asset class within your portfolio is dependent on your individual risk profile. For instance, an ideal investment strategy for the more risk-averse investors or those who are close to retirement may be a higher mix of fixed income/cash and to steer clear of too much equity. On the other hand, an investment strategy for the risk-tolerant investors or those investors who are young may be 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 of my investment strategy is that should you hold about 25% of your assets in fixed income and up to 75% in equities. On the other end of the spectrum, my investment strategy for a 50-year-old entering the final phase of his or her working life to 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 investment strategy should only be used as a guideline and is not meant to be conclusive.
Prudent asset allocation tries to achieve the highest rate of return given the risk. The most basic investment strategy involves understanding how to create an appropriate blend of equity, fixed income, and cash.
To determine your risk profile, you should first understand your investment personality that will help to dictate your investment strategy.
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 is crucial that you stay within your risk boundaries if you are very conservative. For example, if you tend to get jittery when the stock market gyrates, you may want to focus on fixed incomes 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 you should have, as you don’t want to risk your life savings for a hot tip.
Among market watchers, there’s an old saying in the stock market: Bulls make money; Bears make money; Pigs get slaughtered! Translation: Don’t get too greedy and live within your risk profile. This is my investment strategy.
On the topic of risk management, read what other strategies I believe will help to make sure your preserve your capital while also making money in The “Secret” to Successful Investing.