Many investors spend too much time and effort focusing on returns and not enough time looking at risk and asset allocation.

Focus on asset allocation, not returns.

I’ve covered risk in previous articles, so this time I’d like to look at portfolio composition. If you’re like the majority of investors, your portfolio is a mish-mash of stocks and mutual funds constructed in a random fashion with no real effort given to how each component performs as part of the whole.

That’s not good.

Whenever you think about your portfolio, your starting point should always be to decide what your goal for the portfolio is, what level of risk you’re willing to take and how you can meet these criteria by adding the right stocks, in the right amounts.

When it comes to portfolio construction, we’re usually talking about two things: diversification and allocation.

Diversification simply means the number of specific stocks you will hold. You want to hold stocks that behave differently over time. The mathematical term is “low correlation.”

Stocks with low correlations move differently, so when one is going up, another may be going down or not moving at all. If you choose stocks that are highly correlated, that is they always move together (so when one is going up, the rest are too and when one is going down, they’re all going down), your portfolio is not properly diversified, regardless of how many actual stocks you hold.

You also expose yourself to huge potential swings in value and you can’t effectively take advantage of a good rebalancing strategy – which is important because it is rebalancing that ensures you are always buying low and selling high.

If you’re not familiar with correlations or how to use them to properly diversify, sign up for my free report, Stock Market Investing for Maximum Profits, which is a step-by-step guide that explains everything you need to know.

The second step is asset allocation which, for the purpose of this article, is how much money you put into each of the stocks in your portfolio.

Note that when most people refer to asset allocation, they generally include allocating funds to cash, income-oriented investments, such as bonds and treasury bills, and stocks. However I will just be focusing on how you allocate your money between the stocks in your portfolio.

So if you’re holding, say, 10 stocks, then a balanced allocation will have you put 10% of your money into each of the 10 stocks.

However there is a better way.

Using the Sharpe Ratio, you can allocate more of your funds to stocks that have better reward/risk characteristics. Again, if you’re not sure what the Sharpe Ratio is or how to use it, download the free, Stock Market Investing for Maximum Profits, report and it will guide you through the process.

Getting the initial diversification and allocation right is one of the most important things you can do in order to increase your returns and minimize your risk. Once you’re set up correctly in these areas, it’s a simple matter to monitor your portfolio and rebalance when necessary.

The fact is, the vast majority of investors don’t do this and therefore significantly underperform their potential. Don’t be one of this group. Take advantage of the powerful twin pillars of diversification and allocation and watch your portfolio benefit over the years.

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