Balancing your Portfolio

Balancing your share portfolio

Let's assume that you've started to get your personal finances under control. You're aware of your income and outgoings and have ensure that your income is bigger. You've started saving 10% - 15% of your net income each month and begun investing in a pension. You've even begun researching and investing in stocks and shares or index funds. However there is one thing that you're still unsure of: What mix of investments and cash should you hold in your personal wealth portfolio?

Balancing your Personal Portfolio 

There are several schools of thought on how to balance your personal wealth portfolio. For ease of understanding and simplification we will make several assumptions. We will ignore property. Whilst property should be a part of your portfolio property is unreachable for many of us until we have build up a decent amount of wealth first. We will assume that cash and bonds are the same. Likewise, we shall group all investments, regardless of risk profile together. You should have a decent mix of products in both categories, the proportions of which are a discussion for another time.

Share portfolio: The Age Method

This method suggests that you should take 100 and minus your age from that number. That figure is the percentage of your personal portfolio that should be in investments, with the remainder in cash and bonds. The theory is that as your get older you're less likely to want to take risks with your finances particularly as you may have dependants who rely on you or you may rely on your wealth as an income as you get older.

There are a couple of reasons why I don't like this method. It automatically forces a younger person to take on more risk (by having relatively more investments) and an older person less risk. This completely ignores the overall financial situation of the individual. There could be a scenario whereby a young person has large commitments in terms of family and cannot afford to take risks with his finances. Alternatively an older person may not need the money in their old age as they have a large pension, a high paying job or property income. Instead they may wish to try to pass on a big pot to their relatives through an inheritance. In which case they may wish to have a high proportion of their wealth in shares.

Share portfolio: The Risk Profile Method

This suggests that the split in your investments should be in a ratio that you are emotionally most comfortable with. It suggests that if you have a portion of your money in investments, would you be comfortable with it falling to half it's value? Obviously the answer is no! No one likes losing any money, but the point is, what amount would you feel comfortable risking (and potentially losing most of it) and still being able to sleep at night.

Whilst this option caters more to the individual and their taste for risk, it doesn't actually guide you on how you should split your investments. How do I know whether I'm more comfortable with a 34:66 split as opposed to a 35:65 split between bonds and investments? The answer is that I probably don't know.

Share portfolio: The 50:50 Split Rule

This supposes that whatever you age, wealth, risk profile you should always split your money in such a way that 50% is in bonds and cash and 50% is in investments. The theory is that if your investments do well and the split moves away from 50:50 such that it is 45:55, then the rule forces you to sell some shares and buy bonds until the split is 50:50 again. 

The benefit of this method is that it forced you to sell investments when they've done well, and the market is high, and to buy more when they've done badly (I.e when the market has fallen). This encourages good investing habits.

However, I do feel that although this technique encourages good habits, it is a little annoying for someone who may be more comfortable taking on a lot more risk and vice versa.

Share portfolio the 75:25 Split

This method is an adaptation of the 50:50 rule. The difference here is that you can adapt your split based on your risk tolerance. If you're feeling more bullish (thinking that equities will go up) then you can hold 75% of your wealth in stocks and shares. If you aren't confident in the future of shares you must still hold at least 25% in equities. 

This method allows flexibility based on your risk profile and based on your thoughts about the future. It still encourages good discipline to make sure that you aren't buying and selling at the wrong times (ie selling at the bottom and buying at the top).

Portfolio Preference

Personally, I prefer the discipline of the 50:50 rule. However, I appreciate that different people, with different mind sets may prefer a different method. I wouldn't suggest that one method is better than any other.

Readers, are there any other personal wealth portfolio methods out there?

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