There are hundreds of websites and thousands of books devoted to the process of picking stocks and investments. There are potentially thousands of articles published every day, analyzing potential stocks to buy for a portfolio. There are also hundreds of articles published analyzing the portfolios of well-known investors and mutual funds, in the hopes of generating ideas for readers.
However, one issue all of these articles gloss over is the topic of asset allocation. Asset allocation is, in many ways, far more important than the investments you pick for your portfolio.
Even if you own the best growth stock on the market, if you have all of your money invested in this one opportunity, you might be forced to make financial decisions that are detrimental to your financial health in the long term.
Starting at the bottom
Asset allocation starts right at the bottom of your financial situation. It does not apply to just your portfolio. It applies to everything, from your pension, savings account, monthly income, home and credit cards. If you have a lot of borrowing, it does not make sense to invest your money.
Moreover, if you do not have a pension, you should prioritize this before anything else.
It is also sensible to build a large cash savings cushion before you start investing. This will provide a buffer for living expenses if you lose your job, and will protect you from having to sell investments at the wrong time if you suddenly need to cover an unforeseen expense.
There's also a psychological benefit to having a large cash cushion behind you. With this money in place, you do not have to worry about market declines and can take a long-term view, safe in the knowledge that you won't have to change your lifestyle just because the market drops 20% or 50%.
When you've built a solid financial cushion, the next stage is to look at portfolio construction. Once again, this needs to be approached from a bottom-up perspective.
You need to consider your entire financial position when you are planning your portfolio. There's no sense in putting 100% of your portfolio in growth stocks, when you are looking to buy a home in the next five years.
On the other hand, if you already own home, or have enough money put by to complete the purchase, then a higher allocation towards growth stocks might be suitable.
Who you are as an investor
There's much more to consider than just your financial situation when planning a portfolio. You also need to take a look at who you are as an investor.
Do you get worried easily when confronted with investment losses? Then an equity-focused portfolio might not be the best solution for you. If you don't have much time to analyze investments, then stock funds would be a better alternative than single stocks.
These are all things to consider when designing your own portfolio. The aim of the game is to make sure that you build wealth over time, and it is imperative to design a portfolio in a way that is going to help you do this, not hinder you.
You might be able to get better returns by investing your money in equities, but this is not going to work if you get worried every time the stock market falls 2%. It is also not a sensible investment strategy if you do not have enough money on hand to cover living expenses. In fact, this strategy may be downright dangerous for investors who are not prepared to weather the volatility that comes with a 100% equity strategy.
The bottom line
Overall, there is a wealth of literature that's designed to help investors choose their investments.
However, this advice is entirely useless if you are not prepared financially to invest. Being a successful investor is as much about knowing yourself and understanding your entire financial position as it is picking investments. Something investors frequently appear to overlook.
Disclosure: The author owns no share mentioned.
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This article first appeared on GuruFocus.
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