A must-have investment strategy, given the high risk, is a combination of three concepts: asset allocation, diversification, and the need to add small-cap stocks to maximize the expected return of your portfolio.
I would like to discuss the concept of asset allocation as a critical 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 equities.
As the macro and micro factors change as well as your investment objectives, you should rebalance your asset mix and modify your investment strategy. You should also use put options as a hedge against weakness, which I discussed in “Stock Market – Fragile Conditions Mean You’d Better Have Protection.”
Without going into portfolio theory, the risk and expected return of an investment increases as you move along the 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. For instance, adding penny stocks and micro-cap stocks to your investment strategy adds to your total return.
The relationship between risk and return should be used as a guideline for your investment strategy.
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 near retirement age may want a higher mix of fixed income/cash and to steer 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 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 under a prudent investment strategy tells us you should have about 25% of your assets in fixed income and up to 75% in equities. And at 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 tries 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 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 from your barber, which is not a good investment strategy.
And among market watchers, there’s an old saying in the market—Bulls make money; Bears make money; Pigs get slaughtered!
Translation: Don’t get too greedy; but live within your risk profile.