Wednesday, 19 January 2011

The Best Way to Minimize Risk of Your Portfolio: Asset Allocation

The best way to minimize the risk of your portfolio is to carefully balance your assets among various investment vehicles.  Many people think that seeking out the top-performing stocks and mutual funds is the key to successful investing.  They are wrong.

Study after study has shown that individual investment choices account for only 5 or 10 percent of a portfolio's success, while 90 to 95 percent can be attributed to the way the portfolio is allocated among stocks, bonds and money market instruments.

Five Factors of Asset Allocation

When you plan to allocate your assets, you must consider five key factors:
  1. your investment goal, 
  2. your time horizon,
  3. your risk tolerance,
  4. your financial resources, and 
  5. your investment mix.
The three most important personal factors to consider: Your Time Horizon, Risk Tolerance and Investment Objectives.  Read more here:  How well do you know yourself.

Your financial resources relate to HOW MUCH money you have to invest.  The amount of money you have to invest will be a big factor in the risks you want to take.  A small investor just doesn't have the funds to properly diversify a portfolio.  In that case, a well-diversified mutual fund is your best bet for getting started.  Once your portfolio has grown large enough, you may want to take some risk by selecting a more aggressive mutual fund or picking individual stocks.

Your investment mix relates to how you will ALLOCATE what you have to invest.  Historically, the rate of return for large-company stocks has averaged 11.3% between 1925 and 2000.  During the same period, bonds averaged 5.1% return and cash savings averaged 3%.  Rates of return are even higher for small company stocks, but they are also much more volatile.

What chance does your current asset allocation have of meeting your goals?

A portfolio balanced for growth would likely have 60% stock, 20% bonds, and 20% cash.  Using these returns as the average, the portfolio would likely earn 8.4% before taxes and inflation. This is what is called a weighted average.

This is how it works:

60% stock at 11.3%
11.3 x 0.60 = 6.78%
20% bonds at 5.1%
5.1 x 0.20 = 1.02%
20% cash at 3% 
3.0 x 0.20 = 0.60%
Total = 8.40%

You can group your portfolio into these types of baskets and get a weighted average of the return you might expect from the portfolio.  If you have mutual funds, they should calculate what percentage of stock, bonds, and cash are held within the fund.  You can use those percentages when you want to compare this in your portfolio.

Use this information to decide how balanced your portfolio really is and whether that balance matches your savings goals and your risk tolerance.  What chance does your current asset allocation have of meeting your goals?

If your gap is huge and you know you can't meet your goals with the current estimated level of return, you must decide whether 

  1. you can tolerate more risk and try to improve your portfolio's growth potential or 
  2. revise your goals to a level that more realistically matches what your portfolio can achieve.

Your Time Horizon, Risk Tolerance and Investment Objectives.  How well do you know yourself?

Understand what money means to you:  Answer 10 simple questions

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