| Building a Diversified Portfolio - Part One |
by John Jagerson Asset allocation and portfolio management are difficult subjects for many investors. This is due in equal parts to the fact that there is a lack of consensus among professionals as to the best way to approach these problems and the issues can be complicated. These complications can be both cognitive (asset allocation requires a learning process) and emotional (greed often conspires against rational investing). However, there is hope to both simplify the issues and to make it achievable for even very small investors to begin understanding and applying the key concepts behind portfolio management. 
In this article series we will introduce you to the basic concepts of asset allocation through a three step process. You will learn these basic principles. Learn more about asset class diversification in the first article in this series. Learn more about asset class diversification in the second article in this series. Learn more about asset class diversification in the third article in this series. 1. Determining allocation percentages 2. Should you invest in individual securities (stocks, bonds, futures, etc.) or funds (mutual funds or ETFs) 3. Making adjustments and rebalancing a portfolio Learn more about bond and commodity ETFs here. Lets start with determining allocation percentages. Most investment professionals will agree that a blend of asset classes within your portfolio is a good thing but how large those allocations are is a much more cloudy issue. There are basically two factors that you have to consider when deciding on your own allocation strategy. - How much of a bear market burden can you handle - What kind of future returns do you want These two factors are difficult to reconcile. Higher return assets like stocks are often accompanied by very large and unexpected corrections to the downside leading to a large bear market burden. While investment grade and government bonds have a great deal of capital protection they offer low long term returns. Learn more about investing in bonds here. Here is a good example of how two hypothetical allocations acted during different market conditions. 1. An 80/20% mix of stocks to bonds lost -34% in the bear market of 2000-20002 and lost -54% in the bear market of 2008-2009 (so far) 2. A 20/80% mix of stocks to bonds gained 7% in the bear market of 2000-2002 and gained 14% in the bear market of 2008-2009 (so far) When looked at during these periods the bear market burden seems to bias investors towards a more conservative bond portfolio. However, over longer periods of time that include bull markets, the higher risk portfolio (1) will outperform the lower risk portfolio (2) including inflation by a ratio of 2:1. Finding the right mix for you is the real challenge within asset allocation. In the video we will look at how we start solving this problem so that you can refine your allocation yourself. There are concepts that you will learn. First, there are more than two asset classes to choose from and usually the more uncorrelated asset classes you include the better your diversification will be. Second, considering your age and retirement horizon will give you some insight into how heavily you invest in riskier assets like equities. We will start this series by creating a fairly general asset allocation strategy that we can refine as we progress. Support this free service:
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3.25 Copyright (C) 2007 Alain Georgette / Copyright (C) 2006 Frantisek Hliva. All rights reserved." |
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