President Lincoln once said that if he had eight hours to chop down a tree, he would spend seven of it sharpening his saw.  With stock market trading, your diversification allocation is an important strategy to make your investments successful.  The question then is concerning what asset classes to choose, what percentage of your investment goes in each class and what sectors and stocks do you put your investments in for each asset class.

This is probably the most important decision you will make as far as your investment strategy.  Therefore, as President Lincoln advised, do not short your time with this question.  Spend some time looking at the asset classes and their expected return and the standard deviation.  Use an asset allocation calculator which is available online to plot your ideas and see how they fit together.  One example of a calculator can be found at http://www.dinkytown.net/java/AssetAllocator.html.  It allows for input on your current situation and gives a possible start on an allocation formula.  Another site that helps determine asset correlation that is really good is at  http://www.assetcorrelation.com/user/enter_custom_port.

Stock diversification is important because if you have all your investments in like kind asset classes, if the asset class or particular sectors within that asset class has a bad period of time, your entire investment has a bad period of time.  One definition I cam across said that  diversification is the process of spreading your money among different investments to reduce risk.  By picking the right group of investments, you may be able to limit your losses or enhance your gains.

That is certainly the rub.  What group of investments do you select.  After checking their credentials, a financial planner or stock advisor may be a good person to check with.  They can give you advice as to how to begin.  You can plug their ideas in the asset allocation calculator and check if it fits your strategy.  Your strategy will certainly be finessed over a period of time as you test your theories.  This is not bad.  As stated in another area, you can test your theories with play investment sites before you enact it for real with your money.

One analysis I read about suggested putting a portion of your investment in commodities and real estate investment trusts (REIT’s).  The argument is that even though these asset classes are volatile, they will go a long way toward diversifying your portfolio.  Another book I read said that if you invest in REIT’s, than move a portion of your small cap funds to that asset class.  That is an idea you would need to look at and see if it fits your strategy.  Certainly, commodities are a little riskier and volatile.  When the market is down, people move toward them.  However if the dollar strengthens and the market improves, these suffer.

The advice then, is to take your time initially.  Sharpen your saw and determine the correct strategy and mix for you.  Then stick with the system.  You did your homework up front, then trust your system.

Investing in anything other than money market or certificate of deposits will carry a measure of risk. Oftentimes we think of risk in a negative fashion. Risk, however, can be a favorable thing. It is due to the element of risk that our investments can earn a higher return than what can be obtained in money market accounts. If we review our investment strategy and minimize our risk while maximizing our return, we win. Since winning is what we want to do, then we should study and learn all we can about accomplishing that task.

Risk can be thought of as a deviation from the expected norm. If after analyzing an investment, we expect it to generate a 10% return. Risk would be the quantified number that would express the probability that we would not get the 10% return. There is a number that can be obtained that helps us to determine that probability. It is a number used in statistics and is called the standard deviation. It is possible to think of standard deviation in terms of the success we could have in getting the 10% return. The standard deviation can be thought of in terms of a bell curve. One standard deviation means that there is up to a 67% chance that the return will be within one standard deviation of the norm.

Lets say that the expected return is 10% and the standard deviation is 5%. That means there is a 67% chance the actual return will be between 5% and 15%. To make the odds more meaningful, we can add another standard deviation. Two standard deviations gives a probability of a 95% chance of occurrence. So in the example above, there is a 95% chance the return will be between 0 and 20%. So, it is a good investment rule to evaluate the expected return and what the standard deviation is for that stock.

Another method to reduce risk is to start small. Many of us do not start out with a large portfolio to work with. You should never invest more than 3% of your portfolio in one stock. If you have a small trading account, then trade small.

Longevity is the key to being a consistently successful trader. If you are risking 25% of your portfolio on one trade, you are setting yourself up for trouble. Invest small and increase the size of your portfolio through winning. As you win more and more, you will be able to increase your initial investments. After all, 10% gain of $1000 is still 10%. It does not need to be a large investment to obtain a gain.

Setting your financial goals and strategies is another method to manage your financial risk. Knowing what you want to accomplish will help you to avoid getting in over your head. Too many times, we find that stock that is going to hit the home run. It is too pricey for our strategy and does not fit our portfolio goals, but by golly, our friend says it is a winner. Run do not walk from that thinking. Have a goal, stick with it and you will watch your investment grow. Remember, the tortoise crossed the finish line ahead of the rabbit.

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