Why Portfolio Diversification’s the Key to Profit
You buy and sell stocks and have fixed income, but do you know what your overall asset allocation is along with the risk? Too much equity and you are vulnerable to market selling. Not enough equity and you will be left behind should the market rally.
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.
The concept of asset allocation should be a key part of any prudent investment strategy.
Asset allocation refers to the asset mix of your portfolio, which is divided into the three major asset classes—cash, fixed income, and equity. Too much equity and you are vulnerable to selling. Too much cash and you could miss out on a stock market rally.
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 assumed, the higher the expected rate of return; albeit, this is not always the case. For instance, adding micro-cap and small-cap stocks as part of your investment strategy not only 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. Risk-adverse investors or those who are near retirement age may want a higher mix of fixed income/cash, steering clear of too much equity, which makes for a practical investment strategy. On the other hand, risk-tolerant investors or younger investors may want to take a more aggressive approach and maintain a higher mix of equity in conjunction with less fixed income/cash as part of their investment strategy.
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 equity. 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 it 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 principle 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 that 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 equity you should have, as you don’t want to risk your life savings on a hot tip from your barber, which is not a good investment strategy.