Choosing a collection of investments is the first step in building a portfolio, but it is equally as important to develop an effective portfolio strategy. A portfolio strategy pulls all of your assets together in a way that offers you the highest returns while engaging in the lowest possible risks. Effective portfolio strategies often entail properly allocating your assets to achieve diversification and rebalancing them periodically.
Diversification is achieved through proper asset allocation, which involves dividing your investment portfolio among a variety of asset categories. For stock portfolios, you can divide your assets according to sector, region or capitalization. How you allocate your assets depends on your risk tolerance and time horizon. For example, a 20-year-old investor might invest in mostly small-cap stocks because he has time to wait out downturns in the market. A 75-year-old investor buying stock will probably focus on blue-chip and income stocks to preserve his investment portfolio through retirement.
A common portfolio strategy among many investors is dollar-cost averaging. The objective is to invest the same amount of money in your investment portfolio on a regular basis, regardless of the current price of the shares. According to Fidelity Investments, the strategy is most effective when you continue to buy shares in both up and down markets. When stock prices are lower, you buy more shares. You buy fewer shares when prices are higher. The benefits of dollar-cost averaging are that you can profit by investing a small dollar amount per month, and it requires little management if deposits are made automatically.
Calendar rebalancing is a simple approach to adjusting investments according to your preferences. The strategy is achieved by analyzing your investment holdings at a predetermined time, such as once a month or quarterly. Rebalancing your account more frequently can result in high transaction costs, while waiting once a year can cause a severe drift in how your assets are allocated. Calendar rebalancing allows you to make strategic investment decisions and eliminates the emotional aspect of investing.
Threshold rebalancing takes place when your asset allocations change by a certain percentage. According to Dorianne Perrucci of "The Wall Street Journal," threshold rebalancing typically occurs when the weight of your assets changes by at least 5 percent. For example, a particular sector in the stock market remains strong and as a result pushes your technology stock holdings from your preferred 60 percent allocation to 70 percent. To rebalance your portfolio, you need to either sell your investments or buy investments from another underrepresented asset class to readjust the percentages. This approach is beneficial because you make quick investment decisions in accordance to changes in the market.
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