One of the most basic and important things you can do as an investor is to establish a strategic asset allocation, the right asset mix for your portfolio to marry your unique risk tolerance to your return objective. A Baker analogy comes to mind. To make a chocolate cake, the baker must use the right proportion of ingredients: flour, cocoa powder, eggs, sugar and butter to obtain the desired result, a nice moist chocolate cake. This transitions nicely to an investment portfolio, the right mix of: stocks, bonds, mutual funds, GICs, REITs, hedge funds, all important to ensure individual return and risk objectives are optimized.
To accomplish this you, the investor, must established benchmark "weightings" for the various asset classes within your portfolio. This is best done in consultation with a qualified investment advisor who can evaluate your personal financial circumstances and risk tolerance, determining what is best for you. One well-known rule of thumb, one of man, is that your age should match your fixed income allocation in your portfolio. For example, using this principle, someone in their mid-twenties would have a portfolio allocated towards 75% equities (stocks) and 25% fixed income (bonds). A younger person is typically looking for growth in their investments and therefore would have a greater proportion invested in equities. Equities (stocks) as an asset class have historically outperformed bonds by a wide and considerable margin.
The discipline of periodically rebalancing your portfolio back to the strategic target mix simplifies the investing experience. It removes the emotion that can come with the inevitable volatility, the ups and downs and "bull" and "bear" markets. The idea is that when one asset class outperforms the other and deviates from the target asset mix this is corrected by rebalancing. For example, say the strategic weight for equities is 75% and 25% for bonds (fixed income). In this hypothetical scenario, stocks have done well over the past year. In fact so much so that your portfolio is currently at 81% equities, 19% fixed income, to rebalance the investor must sell off enough of the equities position and purchase bonds in order to return to that all-important strategic asset allocation (75/25). This is key to long term returns. Many studies of investment portfolios have shown that more than 90% of returns are attributable to the investor setting, maintaining and consistently rebalancing an optimal portfolio based on their risk tolerance.
Happy Investing!
Michael
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