10 rules for a profitable investment portfolio

Asset allocation - the way you divide your capital among different investment options - accounts for more than 90 per cent of your portfolio’s overall return. Which is why it’s so very important to get the asset allocation right in your investment portfolio.

The portfolio’s the thing

Get used to the fact that, at any one time, a few parts of your portfolio will be doing terribly. Over a long enough time period, each and every component will have had a bad year or two. This is normal asset-class behaviour and cannot be avoided. So, focus on the performance of the portfolio as a whole, not the individual parts.

In asset allocation, job one is to pick an appropriate stock / bond mix

This is determined primarily by your risk tolerance. Do not bite off more risk than you can chew - a classic beginner’s mistake. Calmly and coolly planning for a market downturn is quite different from actually living through one, in the same way that crashing a flight simulator is different from crashing a real airplane. Time horizon is also important. Do not invest any money in stocks that you will need in less than five years, and do not invest more than half unless you will not need the money for at least a decade.

Allocate your stocks widely among many different asset classes

Your biggest exposure should be to the broad domestic stock market. Use small stocks, foreign stocks, and real estate investment trusts (REITs) in smaller amounts.

It makes a difference where you put things

Some asset classes, such as large foreign and domestic stocks, and domestic small stocks, are available in tax-efficient vehicles; put these in your taxable accounts. Other asset classes, particularly value stocks, REITs, and junk bonds, are highly tax-inefficient. Put these only in your tax-sheltered retirement accounts.

Don’t rebalance your portfolio too often

The benefit of rebalancing back to your policy allocation is that it forces you to sell high and buy low. Asset classes tend to trend up or down for up to a few years. Give this process a chance to work; you should not rebalance more often than once per year.

These rules apply to tax-sheltered accounts. In taxable accounts, rebalance only with outflows, inflows, and mandatory distributions; here, the rebalancing benefit is usually outweighed by the tax consequences.

The recent past is out to get you

Human beings tend to be most impressed with what has happened in the past several years and wrongly assume that it will continue forever. It never does. The fact that large U.S. growth stocks performed extremely well in the late 1990s does not make it more likely that this will continue; in fact, it makes it slightly less likely. The performance of different kinds of stocks and bonds is best evaluated only over the long haul.

If you want to be entertained, take up sky diving

Investors like to have fashionable portfolios, invested in the era’s most exciting technologies. Resist the temptation. There is an inverse correlation between an investment’s entertainment value and its expected return; IPOs, on average, have low returns, and boring stocks tend to reward the most.

An asset allocation that maximizes your chances of getting rich also maximizes your chances of becoming poor

Your best chance of making yourself fabulously wealthy through investing is to buy a few small stocks with good growth possibilities; you just might find the next Microsoft. Of course, it is far more likely that you will lose most of your money this way. On the other hand, although you cannot achieve extremely high returns with a diversified portfolio, it is the best way to avoid a retirement diet of cat food.

There is nothing new in investing

Knowledge of financial history is the most potent weapon in the investor’s armamentarium. Since the dawn of stock broking in the seventeenth century, every generation has experienced its own version of tech bust. The recent dot-com catastrophe was just one more act in finance’s longest running comedy. Be able to say to yourself, ’I’ve seen this movie before, and I think I know how it ends.’ The only thing that’s new is the history you haven’t read.

A portfolio of 15 to 30 stocks does not provide adequate diversification

The myth that it does results from a misinterpretation of modern financial theory. While it is true that a 30-stock portfolio has no more short-term volatility than the market, there is more to risk than day-to-day fluctuations. The real risk is not that short-term volatility will be too high, but that long-term return will be too low. The only way of minimizing this risk is to own thousands of stocks in many nations. Or a few index funds.