Asset allocation is the process of determining what percentage should be placed in cash, and what percentage in each industry sector. Asset allocation may account for the success of your portfolio more than the specific stocks you hold, and even more than the timing of your buy and sell decisions.
Diversification involves dividing your capital across and
within a variety of industry sectors. If there is a downturn in any one sector,
this practice can help you manage risk.
Each sector offers different types of risks and rewards;
each industry is also affected differently by economic events. Investments
across different sectors, therefore, gain and lose ground independently. This
protects you from losing your entire portfolio should one stock significantly
underperform, or even lose all its value. In addition, large fluctuations are
often balanced out. For example, if one of your stocks lost significant ground,
chances are that in a diversified portfolio you would hold two or three stocks
in another sector that would balance the loss with predictable income.
There are two specific types of risk to keep in mind when
investing: unsystematic risk and systematic risk.
Unsystematic Risk
Risk that applies only to a specific company. Examples could be as routine as poor sales or as dramatic as an oil refinery explosion. This is one of the reasons why it is unwise to "put all your eggs in one basket;" there is little chance that these events would occur to every company in a diversified portfolio at the same time.
Systematic Risk
This type of risk, however, can affect all the stocks in your portfolio at the same time. Rising interest rates, inflation, wars, and political changes influence the whole economy, not just one sector. It is virtually impossible to avoid these events.
For
example, I am speculating over the historically strongest period of November
through April rather than day trading in the volatile period May through October. I am holding 19% full position in AAPL
(Technology and Retail), 8% position in LPH (Oil and Gas Refining in China), 8%
position in NR (Oil and Gas Services), 8% position in NSU (Gold), and 12%
position in XIN (Housing in China and U.S.).
In
summary, 19% Retail and Technology, 16% Oil and Gas, 8% Gold, 12% Housing and
45% cash to build positions on dips. I selected the stocks that had the highest rate of growth, strongest fundamentals, and significantly undervalued in each of the sectors.
The
only key sector I am underweight in is Banking because I see little growth in the
sector into 2013.
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