Demystifying the stock market: Put those eggs in more than one basket
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There has never been a better time to be defensive with stock market investments. Record highs of more than 25 per cent gains were reached in the American markets in 2013.
Even though Canada and Europe lag, whatever happens to the U.S. in terms of a market decline will definitely affect everyone else.
An asset allocation will protect you by taking the emotion out of investing. You follow the asset allocation, not the fears, hopes and predictions littering the money world.
In 1990, Dr. Harry Markowitz won a Nobel Prize in economics after proving that diversified portfolios (don’t put all your eggs in one basket) maximize return while minimizing risk.
In the end, minimizing risk is the single most important investing goal.
An asset allocation apportions your money among cash (GICs, high interest accounts), bonds and equities. The first two are often lumped together and called fixed income.
Cash is a good place to start. Its role is to cope with emergencies inside and outside a portfolio. Those outside the portfolio include unexpected expenses. Let’s assume that your 100-per-cent equity portfolio dropped 40 per cent in 2008-09, but you needed to withdraw some funds. Without cash you would have had to sell investments at a huge loss.
Cash inside your portfolio also allows you to tweak your asset allocation during times of stock market emergencies. Say you chose an allocation of 15 per cent cash, 35 per cent bonds and 50 per cent equities. When the markets were slammed in 2008-09, the percentage in equities declined dramatically.
Cash offered the chance to buy more equities and bring the percentage back closer to 50 per cent. Here’s where an asset allocation really shines. If 50 per cent equities is your chosen amount, when it drops to, say, 35 per cent you don’t fret about whether it’s time to buy back into the market. You just do it based on the percentages.
Anyone who used cash to follow a chosen asset allocation during the various market declines over the past 20 years is sitting pretty now.