Rebalancing Diversification for the Youth

What level of diversification for the youth? This is an opportunity for the readers to discuss what is the optimal portfolio for a young person just out of college.

What Is Diversification?

Picture from posterize
Diversification in finance means to reduce risk in a portfolio of assets through the increase in the variety of assets. Essentially by increasing the variety of assets you reduce the chances of losing capital. This is because if one particular asset loses money, you can mitigate your loses via gains in another asset class. If instead you only had one asset you might find that the asset goes down in value and that means all your wealth has gone down in value. Clearly the trade-off from having diversification is that your gains may be more moderate, however your loses are also more moderate.

How Much Diversification does my portfolio need?

As already stated, you don't want too much diversification otherwise you lose any possible chances of making large gains. Furthermore every time you buy an asset you will have to pay charges such as transaction costs and taxes. Clearly investing heavily in one asset gives you economies of scale that allows you to reduce your average transaction cost.
So how much diversification is the right amount?
Well the answer depends on your attitude to risk. If you consider yourself a risk averse investor you need to be investing in multiple asset classes: Stocks, businesses, property (commercial and residential), commodities, bonds, structured products, foreign exchange and cash. However if you are more of a risk lover choose three or four assets to invest in and concentrate heavily.
Furthermore you should have diversification within asset classes. For example you should have multiple shares. Buffett suggests 8 to 12 to concentrate on.

Young Diversification

My personal belief is that whilst you are young (just out of college) investors should be looking to invest in the following proportions:

  • 50% in structured products (linked to house prices, bonds and global stock-markets)
  • 30% in individual stocks
  • 20% in cash

The reasoning is as follows:
Most people at this age don't have enough money to properly invest in things like commodities or property. Furthermore, whilst time is still on a young person's side there is still a small need for diversification. The structured product allows for some natural diversification, individual stocks allow for some long term investment gains, and the cash allows for emergencies.
These young investors should be willing to invest in these sorts of products for at least 5 years. Therefore this cannot be money that they will need any time soon.

Readers, how would you rebalance this young person's portfolio and why?

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