The Biggest Mistake That Investors Make
Investors often punish themselves as much as the market does. Despite the compelling case to diversify, many investors hold portfolios with assets concentrated in relatively few holdings. This common failure has its roots in lack of knowledge and just plain laziness.
I’m here to shake you out of your complacency, because in these perilous times, it’s especially important to CYA (cover your assets).
This recent letter from a reader underscores the imperative to diversify:
I enjoy reading your daily articles; they’re quite informative and also entertaining. Right now, I’m anxious about Donald Trump’s affect on the financial markets. I need to make sure my portfolio is properly diversified. Any advice on diversification? I want to make sure that I have the right mix of investments, in case of a correction or bear market. — Alex Z.
Eggs in one basket: a recipe for disaster…
For a comprehensive answer, let’s turn to our in-house income expert Jim Fink, who serves as chief investment strategist of Options for Income and Velocity Trader. As Jim puts it: “Diversification is the key to success.”
Jim has often argued in favor of allocating a portion of your equity portfolio to small and mid-cap stocks. Smaller stocks perform differently than large-cap stocks, sometimes outperforming in the short term and always outperforming in the long term.
But Jim explains that the concept of asset allocation has many layers and does not stop at diversifying the market capitalization:
“The key to investment success is ‘moderation in all things;’ choosing a combination of moderate risk and moderate reward that has the best chance of achieving significant wealth accumulation. The means to this end is asset allocation… the first step in asset allocation is following the old proverb: ‘Don’t put all of your eggs in one basket.’ No matter what the investment, something can go wrong. If you put all of your money in a single investment and it goes bad, you could lose everything.”
Spread the Money Around
Your investment strategy should start with the right asset allocation, tailored to your financial goals.
When creating a diversified portfolio, you must forge an asset allocation plan that closely mirrors your individual investment goals — the way a thumbprint reflects identity.
An asset allocation policy entails dividing a portfolio’s investments among different asset classes. The most common classes are U.S. stocks, international stocks, bonds, cash and cash equivalents, and real estate.
Your asset allocation plan should govern your choices when purchasing stocks, bonds, real estate and other investments. It also should be designed to provide an easy and transparent way for you to determine how your investments are performing.
Asset allocation is an art as well as a science. It’s the investment alchemy whereby you balance several ingredients for the proper admixture of risk and reward.
Asset allocation is one of the most crucial decisions in investing. Investors generate returns through three basic activities: selecting specific investments to buy; deciding when to get in and out of the markets; and establishing asset allocation.
The first two activities are the hardest and least forgiving. However, asset allocation is the easiest to determine —and it wields the most power.
According to financial industry studies, more than three-quarters of portfolio performance and volatility is related to asset allocation.
Of course, in a bull market, your allocation should emphasize stocks. In a bear market, you should lighten up on stocks in favor of bonds and cash. And a transitional market that’s “in between” should strike a balance.
Your Allocation Checklist
Before establishing your portfolio’s asset allocation, first answer these questions:
- What’s the purpose of your portfolio?
Define your portfolio’s purpose. Here are some examples: to reap a lot of money over the short term, so you can make a big purchase such as a house; to generate reliable, future cash flow in retirement; to grow the family estate for your kids and grandkids; to set aside ample cash reserves for entrepreneurial investment opportunities; etc.
- What’s your stage in life?
For example: relative youth (aggressive growth); middle age (moderately aggressive); retirement in the next 10 years (income and moderately conservative); retired (stability and income).
There are several variations. Choose a category based not only on your approximate age, but also on your tolerance for risk. As long-term market history amply shows, you’ll have to withstand a lot of bumps along the way.
- How much wealth do you already have?
What’s your current net worth and how close is it to your ultimate goal? Do you already have a head start, which allows you to shoulder more risk, or are you starting from scratch?
- What’s your self-imposed requirement for a minimum rate of return?
Do you want to reap at least 10% a year? Do you want to at least equal—or beat—the S&P 500? The younger your age, the higher you can set your goals. But be realistic.
- What’s your risk tolerance?
If your portfolio takes a sharp turn for the worse when you’re in you 40s, you still have plenty of time to bounce back. But if your investments take a nosedive while you’re, say, 65, you’re in a far worse predicament.
- Will your financial situation likely get better, deteriorate, or stay the same?
Are you securely ensconced in a paying job that will remain steady for the next few decades? Are you about to retire? Are you afraid of getting laid off?
- Will there be any withdrawals?
If you plan to start taking out money, how much will you withdraw and when?
- What are the regulatory requirements?
Don’t be blindsided by unforeseen rules and regulations. If your portfolio is an Individual Retirement Account (IRA) or 401(k), what are the mandatory distribution requirements?
As noted above, basic asset classes include: U.S. stocks; international stocks; fixed income; real estate (real estate investment trusts, or REITs); and cash and cash equivalents (money market). The appropriate percentages depend on your answers to the above checklist.
Take your time in answering these questions. In my next issue, I’ll convey general “Allocation Scenarios,” which you can tweak according to your specific situation.
Do you have an asset allocation question or story? Send me an email: firstname.lastname@example.org — John Persinos
Get downside protection…and growth to boot
With many analysts now calling for a correction, we wouldn’t blame you for being worried. But we would blame you for sitting on the sidelines. Moneymaking opportunities still abound, even under these volatile conditions.
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