Strategy basics: Allocation & Risk

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There are many aspects to think when you are forming your investment strategy. One of the most important ones is allocation and risk. There are many other ways to calculate your investment's risk, but I would say that allocation is the easiest and most common sense way to manage your risk and return. There are multiple ways to look at allocation, and here I explain few key concepts.

1. Allocation by timing

This is related to my previous post about market timing. Roughly, there are two concepts of allocation and timing. One way is to save money first, and then make few larger purchases here and there. Other way is slowly make smaller purchases. On first approach, you take large risk of market being "high" when you do your large purchase. On later, you do not try to time markets at all. This works vice versa too. On few large purchases, if your timing is good, you will get larger profits than with several smaller purchases. I would recommend small purchases as risk management measure.

2. Allocation by type of holdings

Roughly, you can buy three different types of valuable papers: stocks, bonds and funds. Funds usually invest either in stocks or bonds, or somewhere between. Your stocks/bonds ratio affects your predicted income and predicted risk. I would recommend John Bogle's way of managing your holding types: Take your age, and that is your bond percentage. So, for example, if you are 30 years old, you buy 30% bonds and 70% stocks.

3. Allocation by geography

Having all your money to a single geographical area is a risk. If that area develops well, your return is high, but chances are that single market area is underperforming. I would recommend even distribution around different market areas. If you want more risk and more return, have a larger percentage of your investments in developing markets. If you want more security, have larger percentage of your investments in western markets. Same goes with bonds too, never invest all your bonds into a single country (US savings bond, for example) or single company (company bond).

4. Allocation by quantity

Having big holdings on few companies is a risk. If one of your companies fail, you will loose all your investments into that company. Also, if one is performing over the average, you will get good returns. You can manage this risk by buying index funds or ETFs. For example, iShares S&P500 contains 500 most traded stocks in Northern America. If one company fails, you will only loose 1/500. Of course, it also cuts your profits, but on long term, I would say that buy and hold strategy is best formed via index funds or ETFs. It means, that during the time you are accumulating wealth, you do not have to worry about trading or single company failing your goals.

5. Allocating outside of stock market

You can also allocate some of your wealth outside of stock market. Most common say is to buy tangible goods, like houses. Other way is to buy some raw materials (can be done via stock exchange too) like gold. Problem with gold is that it does not produce anything, so any value gained is just because somebody else wants your gold more. With houses/apartments, you can rent them and get rental income. Of course, any sort of property is expensive to buy, and usually if you end up going on that road, property investments are largest investments of your portfolio. There is a risk too, remember US housing crash few years ago? Stocks have already bounced back, property market isn't.