So often we focus on individual stocks or sectors poised to return huge gains. I get it. We all want to earn big gains in the stock market, right?
But believe it or not, stock picking isn't the biggest determinant of portfolio performance. Let me explain...
Instead of deciding what to buy next, investors should devote more time to identifying what type of security to invest in.
Here's what I mean...
This 18.2% Payer Just Fell Into My Lap
Normally I wouldn't touch something yielding so much. Yields that high are usually a disaster waiting to happen.
But this one is different. You can see why here...
Three researchers -- Gary Brinson, Randolph Hood and Gilbert Beebower -- conducted a study in 1986 involving 91 large pension funds over a 10-year period.
They found that only 6.4% of the variation in a portfolio's returns was determined by market timing and individual stock selection. The other 93.6% is derived from the mix and proportion of various asset classes constituting the portfolio.
This is what is otherwise known as asset allocation. By having an array of securities that zig when the others zag, investors can offset a downturn in any one area and dramatically increase their chances of success.
I know this may sound scary to some of you, so bear with me.
To properly allocate your portfolio, first begin with four simple questions:
1. What are my ultimate goals?
You don't start a trip without a destination in mind. Are you saving for your kid's college? Retirement? A dream vacation? Possibly all three? If so you'll need to quantify how much you will need, taking inflation into consideration. And only then will you have a realistic idea of how much you need to set aside and what returns need to be earned to reach your goals.
2. What is my age?
A retiree who is no longer drawing a salary and living off his or her nest egg can't afford to take the same chances as a new college graduate. The old rule of thumb for equity exposure is 100 minus your age. So a 40-year-old investor might keep 60% of his portfolio in stocks, versus just 30% for a 70-year-old. This is simplistic, but not unreasonable for some people. The point is to build wealth during the early years and then protect it during the later years.
3. What is my risk tolerance?
How would you react to a market decline of 10%, 20% or 30%? Nobody likes volatile, stomach-churning price swings or the thought of losing hard-earned money. But you probably won't reach your goals playing it safe and leaving all your money in Treasury bonds paying 2%. Risk and reward go hand in hand. But don't lose sleep at night either -- find a comfortable balance.
4. Do I want international exposure?
Are you more comfortable sticking with U.S. companies, or are you willing to explore opportunities abroad? Remember that over half of the world's market capitalization now resides outside our borders. International markets can offer higher yields and stronger growth potential (in some cases), and exposure to foreign currencies may shelter a portion of your money from any devaluation of the dollar.
On the fixed income side, you will have to decide whether you want to invest in longer-duration or lower quality bonds to obtain higher yields. And if you are picking stocks, would you prefer smaller, faster-growing companies or larger, established blue chips?
If you are an income investor, you may want this allocation for your portfolio:
- 30% Investment Grade Bonds
- 25% Large-Cap Blend
- 10% High-Yield Bonds
- 10% Floating Rate/TIPS/Inflation Protected Bonds
- 10% Global Stocks
- 10% Real Estate/Commodities
- 5% Small/Mid-Cap Value
Another Way To Go
Or if you want to take the hassle out of the process, consider a group of securities I've recommended in the past to readers of my premium newsletter, High-Yield Investing.
These funds are managed by highly-trained professionals and offer investors an opportunity to invest in diverse asset classes from stocks and bonds to real estate and commodities.
They're called tactical asset allocation funds.
One fund in particular that I've told my readers about has produced positive returns for stockholders in 10 of the past 11 years. It beat 96% of its category rivals and provided nearly twice the dividend yield. Funds like this will not only offer you income and growth, but also offer you a chance to preserve capital and enjoy huge gains. Plus, you'll have the opportunity to generate more income than what you would from a pure stock fund -- and with less risk to boot.
Bottom line, remember to ask yourself the critical questions I mentioned above and plan carefully,. Do that, and you'll have a leg up on most individual investors. And if you're ready to enjoy reliable income from the highest-paying stocks, bonds and funds in the entire market, then I invite you to check out my newsletter.
(This article originally appeared on StreetAuthority.com.)