5 Steps to Simplifying Portfolio Strategy using Asset Allocation
April 3, 2011 Leave a comment
A lot of individual investors are so interested in getting answers to questions like which stocks to buy, at what price and when to sell – that they do not realize that these are the least important questions to get answered when it comes to building long term wealth.
Perhaps the single most important decision that influences long term returns has got to do with allocation ratio of asset types. That is – how much of my income after expenses – i.e. savings – do I put in various types of assets across stocks, fixed income, real estate, gold and cash? This is broadly referred to as portfolio asset allocation in financial parlance – and is the single most decision that impacts long term returns.
For simplifying portfolio strategy, all the opinions and advice can be essentially reduced to, in my view, a set of few simple steps:
1. Decide your asset allocation based on your life circumstances: For an individual who does not intend to do investments full time (i.e. has a job or business for his regular income), an allocation of up to 60% in equity, 10% in gold and the remaining 30% in cash and fixed income might be the optimal allocation. It may not give best returns, but is likely to be something that is practically followed over the long term.
2. Select your core and peripheral assets within the allocation: For most individual investors, index funds or select actively managed mutual funds are the best vehicles for equity participation.
3. Review once a year, and Rebalance when allocation ratios go out of whack: i.e. if equities have grown and now account for 70% of assets, shift 10% into others by selling; similarly if cash/fixed income or gold value has increased, shift proportionately into equity.
4. Set up a system for this: both contributions and rebalancing, so that you do not have to take decisions frequently.
5. Keep increasing absolute amounts or relative asset allocation, as your income levels increase or decrease, life circumstances change or ability to take risk alters.
This can be a framework for deducing a simple investment portfolio strategy for most individual investors. Once this is set up, the investor is likely to realize how unimportant the question of which stock to buy and when to sell really is.