Portfolio Diversification: Your Key to Success
In my view, a critical investment strategy is the concept of asset allocation, diversification, and the addition of small-cap stocks to maximize the expected return of your portfolio. (Read “How to Supercharge Your Portfolio.”)
The concept of asset allocation should be a key part of any prudent investment strategy.
Asset allocation is simply the mix of assets in your portfolio; assets are divided into three major classes—cash, fixed income, and equities. Too many equities, and you’re vulnerable to selling. Too much cash, and you could miss out on a stock market rally. If you had excess cash over the past six months, you would have missed out on some nice gains.
As the macro and micro factors change, you should rebalance your asset mix and modify your investment strategy. Put options should be used as a hedge against weakness.
The more risk, the higher the expected rate of return; albeit, in reality, this is not always the case. For instance, adding penny stocks and micro-cap stocks as part of your investment strategy adds growth potential to your total portfolio return, but it also increases the risk.
The proportion of each asset class within your portfolio is dependent on your individual risk and investment strategy. The more risk-averse investors or those who are nearing retirement age may want a higher mix of fixed income/cash; these investors will also want to steer clear of too much equity. Together, this makes for a practical investment strategy. On the other hand, risk-tolerant or younger investors may want to take a more aggressive approach and maintain a higher mix of equities in conjunction with less fixed income/cash as part of their investment strategy.
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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. Under this scenario, a prudent investment strategy could see you 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.
Prudent asset allocation in an investment strategy attempts to achieve the highest rate of return given the risk. The most basic 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 is critical you stay within your risk boundaries if you are conservative. For example, if you tend to get jittery when the stock market gyrates, focus on blue chips and big-cap stocks.
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 from your barber—which is not a good investment strategy.