Constructing a well-balanced portfolio is a fine art that can be lost among the shuffle of collecting individual positions. Too often, investors are more concerned about finding the right stock or jumping on a new trend, rather than analyzing how it fits within their accounts.
Jumbling together a random series of stocks or funds without any sense of cohesion makes it more likely that you will abandon them at random (inopportune) moments. That path leads to uncertainty of past decisions, weak correlation with the markets, and streaky performance at best. Instead, matching all the right pieces together to suit your risk tolerance and investment strategy will have a meaningful impact on your behavioral choices through good times and bad.
Great investors think of themselves as organizers rather than collectors. They may still shuffle their positions over time. However, there is a method to the madness that makes for a strong navigational tool even when you are uncertain about market direction.
One way to do this is to create imaginary buckets, or sleeves, for each asset class. Stocks, bonds, alternatives, and cash are the four most common types of asset classes found within a conventional investment portfolio. Alternatives may include commodities, real estate, income generating assets like preferred stocks or MLPs, hedge funds, options, and even private equity in some instances.
Once you have identified and placed each investment in those categories, you need to measure the allocation of each sleeve and individual position sizes of your holdings. There is no perfect asset allocation for every investor. Some may be comfortable owning 100% stocks, while others are happy with 25% stocks, 50% bonds, 15% alternatives, and 10% cash. It’s all about understanding the risks of each sleeve and comingling them to serve your individual needs.
For those that prefer to take a more active tactic with their portfolios, it is important to consider minimum and maximum exposure limits for each sleeve as well. This ensures you remain correlated with the markets and your overarching goals, while staying balanced in your asset allocation approach. Without these bands (or guidelines), it becomes easy to justify taking too much risk when things are going well or holding an excessive amount of cash when the markets appear more volatile.
In general, greater diversification tends to lead to less volatility over time. That doesn’t mean it produces the best results. It simply means there are going to be narrower price fluctuations as diverging performance characteristics exert itself on each sleeve.
Another attribute of great investors is they only focus on the things they can control. Market trends, central bank policies, political machinations, weather, war, and other global risks can’t be consistently forecasted. However, it is within your control to determine security selection, position sizing, entry or exit points, and any risk management triggers.