Thursday, March 6, 2008

Forming your portfolio

Your portfolio is considered Good as long as it is Well structured, Diversified and it's risk does not exceed your risk-tolerance level.
Now, what do i mean by well structured? You see, investing is not walking in the park, it's full of dangers and it's always ready to take all your money and run! (Of course walking in park in the middle of the night is not too pleasant either, but at least a mugger can only take the money you have with yourself at that moment.) Now, don't cry, if you follow my advice, you won't need to worry about losing all your money. There are quite a few portfolio risk management tools that you must use.

First of all, it is structuring your portfolio. A well structured portfolio can save you a lot of trouble by itself. Structuring means, assigning a particular percentage of your money to one or another investment instrument. That would be stocks, bonds, real estate, precious metals, artwork, cash etc. The simplest way to structure your portfolio is buying only stocks and bonds. And usually that is more than enough. We'll talk about alternative investment methods later on. Now, bonds have much lower risk (almost risk-free) than stocks, also because the rate of return is fixed, you know precisely what your return will be, that's why bonds should make up a large portion of your portfolio. And then depending on your risk-tolerance, you can decide, how much stocks do you want. Even though stocks are sometimes volatile over the short term, they have proven to be the best investment for long-term growth. In fact, no other investment instrument has provided a higher return over the long term than stocks! That's why stocks should be combined with bonds. Bonds help to stabilise the volatility of stocks, cover short term stock losses and gives a tasty little profit when the times are good.

The second tool, and also one of the most essential is stock Diversification. Diversification is spreading stock investments into different stocks. You would not want to spend all your money on some company's stocks only to see it go bankrupt and lose everything you had. That's why diversifying your stocks is of key importance. Let's say you decide that 30 % of your portfolio would be bonds and 70% would be stocks. Now, you should diversify that 70% of your stocks. IT should consist of at least 5 different stocks in 5 different industry branches and possibly countries. Also it would be wise to choose investment with varying risk levels, as this would ensure that losses are covered by other areas of your diversified portfolio. Diversifying reduces the risk dramatically, which is exactly what we want.

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