Once you’ve selected which stocks to put into your portfolio, the next step is Asset Allocation. There are a number of strategies that have been, and continue to be, used. They range from completely useless to very good.
The simplest way to allocate your stocks is to decide which stocks you’d like to own and divide your investment funds equally between them. Then, periodically, you rebalance. This allocation strategy is better than nothing, but lacks any real ability to use synergies that might be present in your portfolio.
A better method is to use the Sharpe Ratio. The Sharpe Ratio is a measure of reward to risk. The higher the value, the better the investment (from a reward/risk perspective).
Note that a high Sharpe Ratio doesn’t necessarily mean the highest return or the lowest risk. Rather it means that that’s the best you could have done when reward and risk were taken together.
To calculate the Sharpe Ratio you need a stock’s Expected Return and Standard Deviation. You also need the best risk-free rate (typically the interest rate of U.S. Treasuries). The Sharpe Ratio calculation is:
S(x) = ( rx – Rf ) / StdDev(x)
where x is an investment (e.g. IBM), rx is the average annual rate of return of x, Rf is the best available rate of return of a “risk-free” security (i.e. U.S. Treasuries) and StdDev(x) is the standard deviation of rx.
Once you’ve calculated the Sharpe Ratio for each stock in your portfolio, you can use a simple method to allocate your stocks more intelligently than just throwing equal amounts of cash at your stocks.
Here are the steps:
- Compute the Sharpe Ratio for each stock in your portfolio (as described above).
- Sum all of the Sharpe Ratio values.
- Divide each stock’s Sharpe Ratio by the sum of the Sharpe Ratios. This gives the percentage allocation for that stock.
For example, let’s say you have 3 stocks in your portfolio (A, B and C) each with the Sharpe ratio listed in the table below.
Sharpe Ratio Sum
In this case, the sum of the Sharpe Ratios is 8 (i.e. 2.5 + 1.5 + 4.0 = 8).
Divide the Sharpe Ratio for stock A by the sum of 8 to get:
2.5 / 8 = 0.3125 (or about 31%).
Do the same for B and C, and you’ll get 0.1875 (approximately 19%) and 0.5 (50%) respectively.
The results indicate that you should invest about 31% of your money in stock A, about 19% in stock B and 50% in stock C.
The advantage of this strategy is that the better reward-to-risk stocks get a larger share of your investment funds (which is a far more logical way to go than the simple equal allocation strategy described above).
If you’d rather not do these calculations manually, try this Asset Allocation calculator. It will allow you to enter up to 4 stocks and show you an allocation constructed as you’ve just seen.