When the going gets tough smart investors concentrate on asset allocation and diversification. The new investor should too. First we will explain these terms; and then tell you how to put these concepts into action as an investment strategy.
Asset allocation is the process of deciding where to invest and in what proportion. In other words, how do you allocate the money that makes up your total investment portfolio (a fancy word for your list of investments)? For example, you might have an asset allocation of 60% stocks and 40% bonds.
Diversification means spreading your money out across various different investments. For example, the 60% you have allocated to stocks might be diversified or divided among 6 or 60 different stocks. Or, you could get stock diversification by investing in just one stock mutual fund which holds 100 different stocks.
In tough times even the new investor needs to incorporate both financial concepts into their investment strategy to avoid heavy losses in any one area. I suggest you get more conservative in both areas, and at the same time broaden your horizons. Let me explain. Let’s say that at present you are 60% in stocks and 40% in bonds, with emphasis on growth stocks and longer term corporate bonds.
Get more conservative by replacing some of your aggressive stocks with some that are more defensive and pay higher dividends. Cut your bond risk by moving some money into intermediate-term high quality government bonds. Then broaden your asset allocation to include safer and short-term debt obligations like bank CDs and short-term bonds. And expand into alternative investments like real estate, oil, foreign investments and precious metals.
In other words, when uncertainty is high as in 2008-2009, cover all the asset classes and diversify like crazy. Don’t get caught standing flat-footed with a portfolio heavily invested in just one or two areas. Sound pretty challenging for a new investor? Now we simplify.
The new investor can easily solve the diversification issue by simply investing in mutual funds. For example, a conservative value stock fund might invest in over 100 different stocks, and pay dividends of 2% or more. Mutual funds are also the ideal way for a new investor to broaden asset allocation by holding just a handful of different funds vs. a long list of individual securities.
For illustrative purposes, you might put together an investment portfolio that looks something like the following. First, the types of mutual funds are listed, and then the asset allocation percentage.
Money market fund: 10%
Short-term bond fund: 10%
Intermediate-term bond fund: 30%
Diversified domestic stock fund: 20%
International stock fund: 10%
Real estate fund: 10%
Energy fund: 5%
Gold fund: 5%
Total asset allocation percentages must total 100%. In our above sample portfolio you cover a lot of bases with lots of diversification by holding just 8 different investments – all of which are professionally managed for you.
A retired financial planner, James Leitz has an MBA (finance) and 35 years of investing experience. For 20 years he advised individual investors, working directly with them helping them to reach their financial goals.
Jim is the author of a complete investor guide, Invest Informed, designed for average investors or would-be investors of all levels of financial background and experience. To learn more about investments and investing and his new financial guide go to http://www.investinformed.com.