Most novice investors overlook proper asset allocation. However, asset allocation is just as important if not more important than the actual stocks you invest in. The biggest misperception in regards to proper asset allocation is that if you invest in numerous stocks, then you are “diversified” and will avoid catastrophic losses. This couldn’t be farther from the truth.
Let me explain…
We all know someone (or are guilty ourselves) who put a sizable amount of money into one stock and sustained a significant loss. The story and background of the stock sounded great, but at the end of the day money talks. Remember Netflix? We are all familiar with the DVD/Media Streaming service. This stock shot up like a spaceship to the moon based on the revolution of cheap rentals, going from $100 to $300, it almost seemed like you couldn’t lose money. Unfortunately this cinderella story ended badly, take a look…
Netflix went from $300 a share to around $80 in about a year. That’s almost a 75% loss in your investment if you purchased at the top! This is why it’s imperative you invest only in the best businesses at a discount.
By properly allocating your stock portfolio you can WITHOUT A DOUBT avoid catastrophic loss like the example shown above and I’m about to show you how. Here is how I allocate my own personal stock portfolio.
For educational purposes and simplicity assume I have a $100,000 stock portfolio that is made up of entirely cash.
There are three rules that I have, two are non negotiable and the last one has some wiggle room.
1. Do not place more than 5% into one position, PERIOD. No excuses
2. Emplace and adhere to a 25% stop loss on ALL positions. No excuses
3. Maintain 25% of your portfolio in liquid cash. I personally teeter totter between 20-30%
That is it, plain and simple.
Here is an illustation of how my portfolio looks
I have 15 different positions, since my stop loss is 25%, that means I can lose no more than $1,250 on a position. Therefore, I know how much money I’m risking before I invest in a single stock.
Every time I am wrong (and it does happen) I will lose 1.25% of my portfolio, if for some catastrophic reason I am wrong on all 15 positions that adds up to a 18.75% loss on my entire portfolio. That is the ABSOLUTE worst that can happen. Not a penny more.
Some might have the question of, “Well I don’t have a lump sum of money to start a portfolio like this example, what do I do then?”
When I first started investing I had the same issue.
So I looked at my personal financial statement and saw how much money I would be saving each month and the amount I was willing to put towards investing.
For educational and simplicity, I was able to put $1000/month towards investing. That means my yearly contribution would be $12,000. With that in mind, I acted as if my portfolio was $12,000. That means each position would be no more than $600 (5%) and a 25% stop loss would ensure I’d lose no more than $150 per position. Every month I would assess where to allocate my $1000 and build my portfolio holdings slowly.