Asset Allocation and Diversification—The 20% Rule
Before you purchase individual stocks, bonds or even mutual funds, you need to determine your asset allocation strategy based on your ability to manage risk. Asset allocation is the process of selecting different asset classes (stocks, bonds, commodities, real estate) that will enhance the return on your portfolio while minimizing overall risk. Studies have shown that at least 90% of a return on a portfolio is due to asset selection, not individual stock or bond selection. This is important not only because it helps to enhance the return, but it helps investors "stick with the investments" rather than selling at the wrong time. Studies also show that, in practice, a 60% equity and 40% bond portfolio actually performs better overall than more aggressive portfolios because of the simple fact that investors are not as likely to sell out and "give up" due to market down turns.
Minimizing risk does not mean disavowing higher risk investments altogether. It does mean that you create a portfolio with balance—higher risk investments offset by safer investments—and otherwise strive to diversify your portfolio. This is the same principle that makes mutual funds attractive. For example, to diversify your stock investments, invest in several different companies in different markets. Instead of focusing on one company that could go under, spread your money over several companies. That way if one company fails, theoretically, you will have gains from other companies to offset your loss. A good general rule is to have no more than 20% of your investment portfolio in one particular place.
Look at your portfolio from every possible angle and make sure that you are not too heavily weighted in one specific asset class or feature. For instance, geographical diversification involves buying investments based in different world markets. By diversifying globally, you spread out your portfolio over a greater percentage of the world market. You not only gain exposure to potentially higher returns of foreign investment opportunities, you also reduce the overall investment risk of your portfolio as foreign and domestic economies, markets, and currencies rise and fall in different cycles. Also examine industry sectors. For example, health care, telecommunications and energy tend to perform differently in different market conditions. Because there are so many factors that can affect how any single industry sector will perform, it makes sense to diversify your holdings in more than one sector.
To decide if you have fully diversified your portfolio, you may want to bring in members of your financial support team. They can help you sift through the various facets of your portfolio. Remember, much like a diamond, the more faceted your portfolio, the greater the "shine."