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Building an Investment Portfolio III:

Asset Allocation/Diversification

Now that step’s I & II are complete, we can proceed to the area where most investors get lost, discouraged or feel overwhelmed with regards to investing on their own. It’s important to understand that there is no magic formula, computer program or process in order to get the right mix of investment products. There are guidelines, but they are never set in stone. What’s important to remember is to fit the proper proportions to your investment objectives and needs. What I’m talking about here is the balance that investors use to balance risk using fixed income investments with stocks. Someone approaching or entering retirement may want a bond to stock ratio of 80/20 or someone in their 20’s or 30’s may choose a ratio of the opposite, 20/80. Regardless of what ratio you choose, proper asset allocation and diversification will help you to generate more consistent returns without exposing yourself to more risk than is necessary.

Asset Allocation is comprised of three basic groups of investments: Cash, Fixed Income & Equities. Within these three core components, an investor must also consider interest, capital gains & dividends. Although each has an important role to play in a properly balanced portfolio, each had strengths & weaknesses depending on your objectives, goals and tax situation.

Diversification is almost equally as important as choosing the proper asset allocation. Canada is often said to be only a small contributor to the world economy, so it is wise to balance your investments in markets outside of Canada for a variety of reasons. Keeping Canada as a higher percentage of your portfolio than other markets may help to ease your mind on the risk side, but there are both limitations and opportunities to maintaining a weighting exclusively in one or two markets around the world. Proper diversification will take into account not only the market or country you wish to invest in, but also which sectors, industries or asset groups will help balance your risk.

Cost is the final consideration in this section. Nothing is ever free, but it is my belief that limiting the costs associated with your investing activities will help to generate considerably higher returns over the long-term. Generally in life you get what you pay for, but you also want to ensure that the cost of investing is generating equal or greater value for your money than another option. Generally I like to keep the cost of my portfolio (including trading costs & MER’s) less than 1.25%. Higher costs will dramatically affect your earning potential of the portfolio using the structure of compound interest as a guide. If a financial professional informs you that cost is of no or little concern, then you may want to question their motives in handling your investments.

See Also:
Building an Investment Portfolio:
Part I
Part II
Part IV

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