One Thing You Can Do to Protect Your Portfolio From Big Losses

The 2008 financial crisis wiped out a lot of investors.

The biggest reason is because most investors put too much money in one asset class. For example, they may have had all their money in stocks.

One of the reasons this happens is known as the dumb money effect. People tend to put more money in investments that have gone up in value.

It’s the same as following the crowd. Chances are that the hot markets, sectors or stocks will underperform in the future.

There’s one simple thing you can do to reduce your risk and protect your portfolio. It’s one of the most important concepts for investing success…

Diversify across a mix of asset classes.

Instead of investing all your money in stocks, hold a mix of asset classes. A study by Ibbotson Associates, Asset Allocation Is King, shows that 100% of return levels (for example, a fund’s 10-year annualized return) come from asset allocation.

In other words, it’s drives total investment performance. It also reduces the volatility (price fluctuation) of your portfolio.

Let’s look at a simple example using two asset classes…

Investor A owns a stock index fund and bond index fund. The stock fund goes up 50% and the bond fund goes down by 50%.

But if you had half your money in the stock fund and half your money in the bond fund, your portfolio wouldn’t have changed at all.

Investor B has 100% of his money in the bond fund. He’s down 50%.

Investor A reduced risk and protected his portfolio by diversifying across two asset classes. Investor B didn’t diversify across asset classes and lost half his money.

You may hear Wall St. or financial advisors talk about a two-asset class strategy. Something like the old 60/40 stocks and bonds strategy. Which means 60% of your money in a stock index and 40% in a bond index.

Then rebalance it annually. If stocks go down and bonds go up over the course of the year (or vice versa), you bring the allocation back into the 60/40 balance.

However, I suggest you consider holding more asset classes than just stocks and bonds. The idea is to preserve your wealth.

Holding a mix of asset classes is the best way to do that. Talking about all the different asset classes and the right mix for each person is too big to fit into today’s essay.

The point today is to understand the importance of asset allocation. Remember, 100% of return levels come from it.

It’s also the key to avoiding catastrophic losses.

It’s simple to build a portfolio holding a mix of asset classes. Don’t worry, you don’t have to be a sophisticated investor to do it.

You can build a portfolio with ETFs and ETNs. (I wrote a primer on these last week. You can catch up here and here.)

Most investors don’t spend time thinking about asset allocation. Then the stock market crashes and wipes out half their wealth.

It takes years to recover. The market needs to double just for them to get back to even.

Look, you have the advantage over Wall St. Don’t lose it by not diversifying across multiple asset classes.

Take a few minutes this weekend to look at your portfolio.

Are you holding a mix of stocks, bonds, real estate, commodities, precious metals and cash? Or are you holding all stocks?

It’s way more important to spend time thinking about asset allocation than it is to study a specific stock.

It’s the difference between losing wealth in a stock market crash or preserving your wealth for generations.