As you plan your investment strategy, one of the
most critical things you can do is plan your asset
allocation. There is no asset that is entirely risk
free. Different assets hold different risks so as you
diversify into a variety of asset classes, you connect
with different market cycles. Asset classes are
divided into stocks, bonds, cash, real estate and
perhaps commodities.
The hope is that these classes operate on different
cycles and will balance one another for a smoother
ride and reduced overall risk. If the stock market
crashes, all stocks will take a hit, but your real estate
assets may not be affected and your commodities
might go up.
Assets are further divided into sectors or subsets
of an asset class such as commercial, residential,
or manufacturing real estate. It is risky to have all
your assets in one sector. If that sector collapses,
you have no fallback; your portfolio takes a hit.
For example, many people loaded up on dot-com
stocks at the turn of the century. They were ying
high and giving double digit returns. Then came
the crash of 2000 and many investors saw 75% or
more of their life savings wiped out.
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Asset allocation may have more impact on your
overall returns than the specific securities you
choose. A 1986 research report said 88% of
a portfolio return could be attributed to asset
allocation.
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So let’s look at some different ways to
diversify your portfolio.
Diversify by Bonds: Some investment advisors
recommend diversifying into different sectors, or
kinds of trading instruments. The old standard is
a ratio of stocks and bonds, typically 75% stocks,
25% bonds. And the ratio changed with a high
percentage moving into bonds as you aged. In the
past, these two had an inverse ratio. If stocks went
up, bonds went down and vice versa. But this is no
longer the case. Stocks and bonds can fall or rise
at the same time, making this strategy less diverse.
Diversify by Asset Sector: Asset sectors are
another form of diversity. Broadly, sectors are
divided into 4 major categories:
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1. Natural resources: farming, mining, forestry, etc.
2. Manufacturing: building, and processing
3. Service: medical, retail, entertainment, finance
4. Intellectual: colleges, education
Within these sectors, securities breakdown to
further divisions:
Consumer discretionary
Consumer staples
Energy
Financials
Healthcare
Industrials
Materials
Real-Estate investment trusts (REITs)
Technology
Utilities
The belief is that when you allocate your assets in
a variety of these sectors you can protect yourself
from dramatic drawdowns. Traditionally, consumer
28
‘Principle 2: Develop a suitable asset allocation using broadly diversified funds’, Vanguard,
and ‘The global case for strategic asset allocation’, Vanguard https://institutional.vanguard.com/iam/pdf/VIPS_global_case.pdf
29
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staples and energy have done well in recessions
while financials and technology outperform in an
uptrend. As all these are traded on the exchange,
they are sensitive to not only their sector cycles
and swings, but also total market reversals. The
stock market crash of 2007 crushed all assets. A
broadly diversified portfolio still lost 57% in the
next two years.
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Diversify by Size or Location: Advisors may also
suggest diversifying by moving into international
equities, emerging market assets, or small-cap
investments when they feel these are moving into
an up-cycle.
Diversify into Physical Assets: Broader
diversification includes moving out of traditional
investment assets into currencies, art and
collectables, physical metals, real estate, and
business ownership. Today, investors are spreading
their wealth into a new asset of cryptocurrencies.
Most advisors agree that the more diverse your
investments, the more secure your portfolio.
However, remember that each kind of security
carries its own risks. For example real estate is
illiquid. It can be hard to sell quickly. And if you
must have a fast sale, you will sacrifice price
to make it happen. Pharmaceuticals have the
potential to return greater profits, but political
decisions or a bad report may send them tumbling.
And currencies can change with political climates,
natural disasters, or trade imbalances.
The ratio of how you invest in these asset classes
also matters. You may want to divide your portfolio
over all the sectors with perhaps 5-10% in each
sector. You may be conservative and place 50%
of your investments into blue chip assets of long-
standing quality and security, then divide the rest
over assets that may carry more risk, but also have
more upside potential. And you may take 5-10%
30
Leary, Elizabeth, ‘5 Strategies to Lower Risk’, Kiplinger, 31 Dec 2011
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of your portfolio and risk it on junior miners, tech
start-ups, or other high risk assets.
Exchange Traded Funds (ETFs), index funds, and
mutual funds are designed to mitigate risks by
investing a broad spectrum of assets within a
group or sector. These make it easy for beginning
investors because the assets may be managed by
others to assure diversity and proper allocation.
They let you invest in emerging markets without the
risk putting all your money on a single company.
While ETFs and index fund are considered safer,
a deep sell-off will cause your security to drop
in value. Open ended mutual funds may also be
forced to sell assets at a loss if too many investors
pull their money out at once.
Social trading offers another method to diversify
your portfolio. It’s easy to copy another trader
and automatically gain the benefit of his or her
experience. Your investments are diversified
exactly as the investor you are copying. Because
you can allocate a different amount to each trader,
you have the chance to diversify your portfolio over
an exceptionally broad range of investments.
The key is to know what kinds of instruments each
trader invests in. There’s no diversity in using copy
trading if everyone you copy is invested in the same
currencies. You’ll have more diversity if you choose
to copy a trader in currencies, one in US stocks,
one in global stocks, one in commodities, etc.
eToro also offers CopyFunds™ that invest in
certain asset sectors. These funds are managed
by eToro and some are based on the trading of
select Popular Investors. Each uses eToro’s unique
algorithms to manage risk and diversity. Again, you
can easily diversify by allocating a percentage of
your funds to trade with different CopyFunds™.
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Just remember, all trading involves risk. Only
risk capital you’re prepared to lose and past
performance does not guarantee future results.
In truth, asset allocation is specifically about you.
Your goals, your money, your risk. What is the
correct allocation for you may be totally wrong
for someone else. So don’t blindly follow what a
mutual fund, investment advisor, or guru tells you.
It’s critical to see how it aligns with your needs and
goals.
Age: Many financial advisors categorise asset
allocation by your age. They say if you are younger
and have a longer working timeline, you can afford
to take on greater risks. You have the time to make
up losses. You can let compounding work in your
favour.
As you work on your asset allocation, look at the
number of years you expect to work. Consider the
deposits you can make into your portfolio each
week, month, or year. Continually adding to your
investment portfolio increases the probability it will
grow faster and allow you to reach your goals.
Timeline: This is a good time to look at retirement
calendars.
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They will ask you questions such as:
How much have you already saved for
retirement?
How much money would you like to have each
year in retirement?
Will you get money from other sources?
When do you expect to retire (age/year)
How long do you think you’ll live?
What rate of ination do you want to plan for?
What kind of taxes are you paying now?
What tax basis do you estimate when you retire?
How much can you invest each month? And
6.1 Assessing Your Timeline and Goals
31
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when will you stop putting money into your
account?
Will you have other sources of income - pension,
annuity, government support - when you retire?
What do you anticipate for your average rate of
return on your investments?
These online calculators crunch the numbers and
give you an estimate of your retirement potential.
The advantage of retirement calculators is that you
can try different numbers and check the results.
See what happens if you delay retirement a few
years. How do the end numbers change if you
increase your monthly contribution? What if the
average returns go up or down? The goal is to help
you see how much money you will need saved or
invested in order to retire at the comfort level you’d
like.
It’s much better to have realistic return rates and
a longer timeline than to hope for higher returns
that may come with greater risks. In general, the
shorter the time between now and retirement,
the less risk you’ll want to take on with retirement
money. However, you may set aside some money
for trading in the hopes of growing that money
faster.
Goals: You may have goals other than retirement.
You may want your assets to bring in current
income or to buy intermediate purchases such
as education, a car, or a home. Part of the asset
allocation is to produce the income you are looking
for.
Traders may be seeking monthly income. They will
need to find underlying assets that have volatility
and movement that is cpable of producing the
income they seek. Still, they will find less risk as
they diversify into different markets to protect
against cycles, news, or swings. The hope is that
the different markets will add balance.
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You may lean toward assets that pay dividends
for monthly income. Or you may plan not to touch
your securities for years. In that case, less liquid
investments such as real estate or a business may
keep your money in a secure place until you need
it. Diversifying your portfolio may mean you use
many financial instruments to accomplish your
goals.
Since every kind of investment carries its own risk,
you’ll need to figure out your risk tolerance. This is
both an emotional and a financial decision.
On the financial side, look at your portfolio and
your timeline. If you lose 20% on an investment,
what will that mean to you? Do you have time to
work to make it up? Do you have enough invested
that you can afford to take some of your money to
speculate? If it disappears, will you be able to pay
bills? Retire? Have your current lifestyle?
On the emotional side, what kinds of losses can
you tolerate? Do you find yourself worrying when
a trade goes against you? Do you get sweaty hands
as a security drops? Do you live on ‘hope marketing’
where you hope the market will rise… but you are
afraid it won’t?
You know yourself. If aren’t sure how you will react,
pay attention as you go through a few trades. If
you think, ‘That loss stinks, but on the whole, my
trades are working out well,’ then you are working
within your risk tolerance. If you find yourself
obsessing over every trade and every loss, stop
and reevaluate.
You may feel more comfortable about temporary
drawdowns if you consider these things.
6.2 What is Your Risk Tolerance?
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Have I learned enough about fundamental and
technical analyses so I have a feel for the trend
and resistance points?
Have I chosen copy investors who have a track
record I can trust?
Should I stick to lower risk securities and try a set-
and-forget method using rising dividends and
blue chip assets that have historically provided
a good return,so the swings don’t bother me?
Can I put my emotions on hold and trade with
set stop losses and profit taking to ride out short
dips and minimise losses?
Have I allocated money to both long term growth
for security and to short term trading for the
potential for higher rewards?
For most investors, as they gain experience, they
find a comfortable spot for themselves. They learn
their risk tolerance and stay within it. And, when
they find themselves falling for a ‘sure thing’ that’s
riskier, their fears and emotions eventually pull
them back into what they consider a ‘safe zone’.
Leverage: Leverage lets you use a fraction of the
equity to control large lots of investments. This is
inherently much riskier than simply owning a stock
or buying a CFD. Your profits are multiplied, but you
run the risk of losing more than your investment.
This is one place to check when you want to adjust
your risk tolerance.
You may want to begin by buying assets with no
leverage. With a CFD, it costs almost nothing and
there are no carrying charges on unleveraged
assets purchased on eToro. As you see your
investment decisions bearing good fruit, you may
move to leveraging 2x, 5x, or 10x, or at maximum
25x. Then it may make sense to trade in currencies
that need leverage to take advantage of small price
movements. eToro guides you with suggested (and
perhaps required) stop loss settings to reduce risk.
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CFDs also allow you to sell assets you do not own
to take advantage of a down market. Short selling
CFDs, even unleveraged, creates a carry charge.
Leveraging your trade can produce outsized gains
or losses.
Compounding: Compounding has been called
‘getting rich slowly’. It is considered a low-risk way
to earn considerable income over 40 to 60 years or
more. Stocks, mutual funds, ETFs and CFDs can all
pay dividends. This is cold, hard cash right into your
account. It’s not paper earnings you may redeem
in the future.
Here is an example. Say you bought Realty Income
shares on 31 December 2006 and collect their
dividends for the next 10 years. In that time you
would have seen:
8.8% yield on cost (vs. an original yield of 5.5%)
60% increase in dividend income amount
108% increase in the value of shares
69% of your original investment returned to you
as dividend income
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You may be able to set your account to have
those dividends reinvested into the security. This
gives you a greater share of securities. That give
you more dividends so you buy more securities,
which gives you more income…. You can see how
the amounts add up. If you keep adding to your
investments and reinvesting the dividends, the
return has the potential to go up exponentially
with time.
For example, the chart shows potential gains with
these assumptions:
Initial investment of $10,000
Initial dividend yield of 3.5%
Capital appreciation rate of 5%
Dividend growth rate of 5%.
The chart assumes you reinvest the past year’s gain
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‘The Magic of Rising Dividends’, Realty Income, http://www.realtyincome.com/about/magic-of-rising-dividends/
98
at the beginning of the next calendar year. Plus
you add $1,000 in new capital each year You will
have slightly higher growth if the dividends are
reinvested as soon as they are paid. This chart
assumes the portfolio is held in a tax free account.
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You may change both your investment strategy
and your asset allocation over time. When you
first start trading, you may trade in ETFs indices,
and CopyFunds™ so that others help you with
your investment decisions. It’s so easy to start by
simply finding a trader with a suitable risk level
and diversity to invest with. If you find this method
satisfactory for you, you may simply continue like
this forever.
As you gain experience, you may choose to develop
your own method of choosing trades and the time
you want to hold a security. It may be that you grow
to be a trader and have others copy your trades.
It’s nice to know that eToro has a system to reward
traders that others copy. That can be a source of
additional income.
Keep in mind that most traditional investors do
not have the broad array of investments available
to CFD online traders. They must stick to stocks,
bonds, ETFs, index funds, and metals that are
traded on their national exchanges. This often
excludes currencies, cryptocurrencies, some
commodities, and many securities from other
nations. eToro Copy Traders on the other hand
can easily diversify into all those categories.
Hundreds of companies from around the world
are tradeable on CFD trading platforms. They can
trade American, Australian, British, French, Russian,
and South African equities as easily as they trade
their home country’s assets.
6.3 Developing a Risk
Tolerant Strategy
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Dividend Growth Machine, ‘Illustrating The Factors That Affect Dividend Growth Investing’, Seeking Alpha
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Your investment strategy may be tied to one or
some of the trading strategies listed below.
Currencies: Watching news, economic and
political events to determine if you believe a
currency will rise or fall against another currency.
Day trading: Trends, news events, quarterly
reporting periods and other market moving
information is the food for these short moves.
Global markets: Watching the tide ebb and ow
for different parts of the world and shifting funds
to take advantage of the growth in China, South
America, or other bright lights has performed
well during some times.
Rising cycles: Commodities and other assets
follow general cycles. Moving your investments
from cycles that are topping out into cycles that
are beginning to rise.
Rising dividends: Assets that have paid
consistent dividends and increased their
dividend payments (never decreasing them)
over a period of years have been shown to
outperform non dividend assets over the long
time frame.
Value equities: Investing in assets with a low PE
ratio and low debt has been a well-used strategy.
The purpose of this book for you to become an
educated investor. This learning is a two-way street
that needs your input. As you learn about yourself
and your risk tolerance, you will understand how
to use the knowledge in this book to master your
trading.
Please don’t skip over the asset allocation and
risk tolerance part of trading. Take the time to
learn your timeline, risk, and investment strategy.
Calculate what you’ll need to retire and start putting
money toward that now. Your goal is to become
a smart, successful investor, and build a portfolio
that supports your chosen lifestyle. That can only
happen to the degree you plan for the risks inherent
in all investing.
Your capital is at risk. Cryptocurrencies can uctuate widely in prices and are therefore not appropriate for all investors. Trading cryptocurrencies is
not supervised by any EU regulatory framework. Past performance does not guarantee future results. This information is for educational purposes
and not investment advice.
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