Fundamental #1: A Focus on Asset Allocation
Most people assume that investment performance is dictated by the stocks that you choose to place in your portfolio. This is wrong and dangerous - dangerous because it pushes the investor to focus on the wrong thing - stock selection.
90% of an investment portfolio’s performance is determined by asset allocation. Asset allocation is the mix between stocks and bonds in your portfolio. This mix will work to determine how your portfolio does into the future. It has to do with the risk the investor should take. A 100% stock portfolio may provide good returns, but at great risk which can mean lower returns over time. However, a well balanced portfolio will help manage that risk for you.
Fundamental #2: The Right Asset Allocation
If a focus on the right asset allocation is fundamental #1, then it makes sense that the 2nd fundamental is choosing the right asset allocation for you. There are a number of ways to do this, but an easy and effective way to do it is with the following formula:
Your Portfolio’s Stock Allocation = 100 minus your age
For example, lets say you are 33 years old. To determine what percentage of your portfolio should go to stocks you simply subtract your age from 100 (100-33=67). 67% of your portfolio will go into stocks. The remaining 33% of your money must be allocated to bonds or other fixed income and safe securities.
Fundamental #3: Use Index Funds for Diversification
The portfolio, or mix between stocks and bonds, you set up will have a large impact on your portfolio returns. However, that is not enough. You need some further protection from the risks of the market. That is where diversification comes into play.
Within your selection of stocks and bonds, you should ensure you are properly diversified through the use of index funds. Index funds invest in a wide range of securities as opposed to one or two stocks or bonds. With just one index fund you get access to hundreds or thousands of stocks. This provides you with a much higher level of diversification than you would get if you simply bought a couple stocks and bonds.
Investing does not need to be hard, and those brokers and advisors are simply salespeople trying to convince you to invest your money with them. Instead, take some time to educate yourself on the investment process, build your portfolio with a strong asset allocation and a diversified portfolio and you will be off to a good start.