All investors should have a specific plan for portfolio diversification. The key to determining the percentage allocated for each asset class is in using percentages to diversify investment holdings. This smooths out the risk-and-reward profile of a variety of asset classes over a particular time frame. To be properly diversified, you should allocate different percentages of your investment funds across stocks, fixed income, cash and cash-equivalent asset classes. It is important to define your time horizon regarding when the money will be needed. In addition, you should understand your tolerance for risk to facilitate the appropriate percentage allocation to each asset class.
Things You'll Need
- Brokerage account
- Bank account
Determine your time horizon for the investment capital. If the time horizon is less than five years, the portfolio needs to be more heavily weighted in bonds and cash equivalents. If your time horizon is greater than five years, the portfolio can have a higher percentage in stocks.
Determine your risk tolerance. If you have a higher risk tolerance (you're a risk taker), a bigger percentage can be allocated to stocks and bonds. If you have a lower threshold for risk (you're averse to risk), a higher percentage needs to be divided into bonds and cash equivalents.
Determine the total dollar amount of your investment funds.
Allocate 60 percent to stocks, 30 percent to bonds and 10 percent to cash equivalents if you're a risk taker with a long time horizon. If you have a long time horizon but you're averse to risk, allocate 60 percent to bonds, 25 percent to stocks and 15 percent to cash equivalents. If you have a short time horizon and you're a risk taker, allocate 55 percent to bonds, 30 percent to cash equivalents and 15 percent to stocks. If you have a short time frame and you're averse to risk, allocate 55 percent to cash equivalents, 40 percent to bonds and 5 percent to stocks.
Within the stock asset class, allocate 60 percent to large caps (market capitalization of $5 billion and above), 30 percent to mid caps (between $1 billion and $5 billion) and 10 percent to small caps (less than $1 billion). Market capitalization represents the total value of the company and is calculated by taking the total number of shares outstanding and multiplying that number by the current share price.