Everyone wants their investment positions to keep rising. But with the shifting market values, investors should always be prepared for a downturn. Volatility is normal. If markets were constantly soaring, trading would be boring and everyone would be rich. However, price swings can be disastrous when you channel all your funds to one asset. By investing in different securities and industries, you protect the entire portfolio from sinking during a market crash.
However, diversification goes beyond purchasing a bunch of assets. You need to allocate the shares appropriately for a balanced portfolio. If you’re thinking of buying stocks for entertainment or learning purposes, you can consider building a “fun portfolio”. Fun money adopts a relaxed and experimental investment approach. As such, your fun investment allocation should remain below 10% of your investment to minimize risk in case of a loss.
Your Portfolio Allocation
There is no universal system for portfolio distribution. It all depends on your investment goals, risk tolerance, age, and duration in the market. Here are some popular allocation models.
The 5/25 Rule
This rule aligns portfolio allocations with your investment goals. The “5” implies you have to rebalance any allocation that deviates from your portfolio by 5%. Conversely, the “25” represents smaller assets that constitute 5-10% of your investment. Rebalancing should only happen when an asset’s share exceeds an absolute 5% or 25% of the initial target allocation.
When you rebalance a portfolio, you restore its original structure by purchasing what performed poorly and selling high-performing assets. Young investors can rebalance using the new money entering their accounts. However, older investors approaching retirement should buy and sell positions within their portfolios to minimize risk.
The 60/40 Portfolio
This classic portfolio distributes 60% to stocks and 40% to bonds. As such, stocks perform well in a strong economy while bonds do well when the market is weak. But although the 60/40 portfolio has generated steady returns historically, this allocation might not be viable in the coming years.
For starters, inflation and low-interest environments could affect bond yields. You might miss out on bull market gains when you channel a large portion of your investment to fixed-income assets. Another downside is the fixed allocation. A 60/40 arrangement might be too safe for young investors and too risky for their counterparts nearing retirement.
The Rule of 110
This formula calculates your stock investment percentage as your age subtracted from 110. Assuming you’re 40 years old, you should invest 70% (110-40) in stocks and the remaining 30% in cash and bonds. The rule of 110 follows a simple concept; young people are luckier with aggressive portfolios since they have more time to recover losses and build wealth.
On the other hand, older investors do well with low-risk portfolios. As you approach retirement, your focus shifts from wealth generation to retention. This rule has several variations. Depending on your risk tolerance, you can use the rule of 100 or 125.
Your “Fun Money” Allocation: Less Than 10%
The temptation to try speculative investments can be too strong to resist. However, your fun investment allocation is a gamble; one slight miscalculation and you lose it all.
That’s why fun money shouldn’t exceed 10% of the portfolio. Some investors even keep the amount between 3% and 5% to minimize risks further. What’s more, open another account to separate your fun money from other investments. That way, you’re not tempted to dip into other investments to offset losses from your fun portfolio.
This goes together with monitoring your accounts. You can check your accounts daily to see whether the portfolio confirms your short-term speculation. At the same time, review your accounts after several years to see whether the investment paid off.
Even if your fun money multiplies, don’t be overconfident and increase the allocation. In most cases, the performance of your fun investment allocation depends on fun instead of skill. You may not replicate the original performance when you make a similar investment with your remaining assets.
Monitoring your accounts also helps with tax reporting. If the play money remains in taxable accounts, you’re obligated to disclose sales on tax returns. Remember to conduct some due diligence when building your fun portfolio. Your investment is safer with a reputable financial partner.
How to Invest Your “Fun Money”
Feel free to get creative with your fun investment allocation. For example, you can buy gold stocks to get some exposure to precious metals. You could also invest in cryptocurrency or jump on a trending stock. The venture may not reward you financially, but it will teach you something about the market.
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