Stock Market Today

There are many forms of risk management such as overall diversification  with the use of various asset classes, the ratio of equities  to fixed income, and the use of long-term trending to periodically change the asset allocation. Since I prefer to use mutual funds rather than individual stocks, diversification is easy to accomplish. As a matter of fact, many of my clients who have decided on their own investment options in 401k’s are frequently over-diversified.

* Overall Diversification and the Use of Various Asset Classes

The basic asset classes that I use to diversify portfolios are Stocks (small, mid, and large cap), Real Estate (REITS), Commodities (Metals, Natural Resources), Bonds and Cash. Most experienced investors recognize the need for overall diversification, which can take place in many different ways. My rule for individual stocks is that no single stock should

represent more than 5% of a given portfolio. This rule prevents what I call “single stock risk”, so that an Enron, WorldCom, or PG&E debacle cannot significantly damage a portfolio. There is also the need for industry diversification. Even though energy stocks did well in 2005, we would not want our portfolios to consist of 80% energy stocks.

* Tactical Asset Allocation Strategy

The awareness and use of long-term trending and re-balancing of the asset allocation is another form of risk management. This does not mean going to 100% equities in one cycle followed by 100% fixed income in another cycle. Some cycles may call for minor changes to the basic asset allocation while others may call for major changes. The awareness of these cycles combined with the investor profile should dictate the appropriate changes.