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 flying 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.
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.28 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:29
- Natural resources: farming, mining, forestry, etc.
- Manufacturing: building, and processing
- Service: medical, retail, entertainment, finance
- Intellectual: colleges, education
Within these sectors, securities breakdown to further divisions:
- Consumer discretionary
- Consumer staples
- Real-Estate investment trusts (REITs)
The belief is that when you allocate your assets in a variety of these sectors you can protect yourself from dramatic drawdowns. Traditionally, consumer 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.30
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% 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 Smart Portfolios™ 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 Smart Portfolios.
Just remember, all trading involves risk. Only risk capital you’re prepared to lose and past performance does not guarantee future results.
6.1 Assessing Your Timeline and Goals
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.31 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 inflation 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 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.
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.
6.2 What is Your Risk Tolerance?
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.
- 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.
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 income32
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 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.33
6.3 Developing a Risk Tolerant Strategy
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 Smart Portfolios™ 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.
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 flow 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 whole purpose of this book is to help you become an educated investor. This learning is not a one-way street. It needs your input. As you learn about yourself and your risk tolerance, you will better 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, investment strategy, and risk tolerance. Plan your future by calculating what you’ll need to retire and start putting money toward that now. The goal is to see you become a successful investor who trades wisely and builds an impressive portfolio that allows you to live your chosen lifestyle. That can only happen to the degree you plan for the risks inherent in all investing.
This is a marketing communication and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to buy or sell, any financial instruments. This material has been prepared without having regard to any particular investment objectives or financial situation, and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as, a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this publication, which has been prepared utilizing publicly-available information.
eToro is a multi-asset platform which offers both investing in stocks and cryptoassets, as well as trading CFDs.
28‘Principle 2: Develop a suitable asset allocation using broadly diversified funds’, Vanguard, https://personal.vanguard.com/us/insights/investingtruths/investing-truth-about-risk and ‘The global case for strategic asset allocation’, Vanguard, https://personal.vanguard.com/pdf/ISGGAA.pdf
29‘Sector’ Investopedia http://www.investopedia.com/terms/s/sector.asp
30 Leary, Elizabeth, ‘5 Strategies to Lower Risk’, Kiplinger, 31 Dec 2011 https://www.kiplinger.com/article/investing/T041-C000-S002-5-strategies-to-lower-risk.html
31 https://tools.finra.org/calcs/1/retirement or https://financialmentor.com/calculator/best-retirement-calculator
32‘The Magic of Rising Dividends’, Realty Income, https://www.realtyincome.com/about-realty-income/monthly-dividend-commitment/the-magic-of-rising-dividends/default.aspx
33 Dividend Growth Machine, ‘Illustrating The Factors That Affect Dividend Growth Investing’, Seeking Alpha http://seekingalpha.com/article/704231-illustrating-the-factors-that-affect-dividend-growth-investing?page=2