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Diversification thru Allocation

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Change — sudden, unpredictable, and dramatic — has been demonstrated again and again in recent years. Whether the shifts are political, economic, global, or personal — change is as inevitable as it is unpredictable. Understanding this and taking it to heart, leads us to the philosophy that appropriate diversification is a key to security, contentment, and wealth in these difficult times. You simply don’t want all your eggs in one basket!

Your initial approach to diversification should be framed by the process of “asset allocation” — deploying your investments among major asset classes such as stocks (or equities), bonds, real estate, and cash. Asset allocation is a pillar of modern investing practice. Studies have found that fully 90% of the variation in investment returns is due to asset allocation, as opposed to market timing or stock selection.

Your asset allocation should be primarily a function of your risk tolerance. Your ability to take on risk is a function of both your emotional and financial resources. Your emotional capabilities give you the strength not to panic out when an asset class is having a bad year, or more. And your financial means give you the cash flow to outlast inevitable market cycles in your investments.

There are almost as many approaches to risk profiling and asset allocation as there are advisors. They range from the highly academic and complex (picture 10-page psychological questionnaires coupled to 20-position portfolios with allocations computed to the half percent), to very simple rules of thumb. I favor simple rules, with a conservative tilt. After all, the entire subject is hypothetical until you actually experience a severe market cycle. Then you will truly know yourself, in very real financial terms.

Action Items

  • Choose your allocation to bonds plus cash, using one or more rules of thumb:
  • Ask what percent of your portfolio you could stand to lose for a few years. Double that answer, subtract it from 100, and consider that your bond plus cash allocation.
  • Or, use your age, rounded up to the nearest 5 or 10% as your bond plus cash allocation.
  • Or, if you’re an older, more experienced investor, consider a 50/50 stock/bond allocation as your starting point. Adjust from there depending on personal factors.
  • Analyze your remaining allocation to U.S. stocks.
  • Analyze your remaining allocation to international stocks.
  • Analyze your remaining allocation to real estate.
  • Consider a starting 5% position in contrarian or local assets that are isolated from the global financial system — precious metals, commodities, collectibles, rental property, or a small business, for example.

NEXT: Rebalancing for the Real World

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