Develop Financial Plan

The ultimate goal of collecting and analyzing all kinds of financial information is to lay out a good financial plan, which should be not only realistic, but also producing respectable returns to help an individual to realize his/her financial goals.

Diversification

The basic idea of a good financial plan is diversification. The concept is simple, don't put all your eggs in one basket. A well diversified portfolio can eliminate the non-systematic risk (company-specific risk), maintain the value of the portfoilio, while providing growth in the long term.

Research shows that 10-stock portfolio can reduce the portfolio risk by 46%, while a 30-stock portfolio can eliminate 90% of risk. Canadian market is a fairly small market. Comparing to the grand scheme of global market, TSX only represents roughly 3% of global market. 75% of TSX is focused on Financial, Energy and Materials sector, 4% on Information technology, and 1% on Health care.

Understand that diversification is a conservative strategy that acknowledges you may not always be right when it comes to select the investments. It will help you smooth out the ups and downs in your portfolio performance and achieve consistent growth in the long run.

Asset Allocation

Diversification is realized through asset allocation. Simply put, asset allocation means the percentage holding of each investment products (asset mix) in the portfolio. It involves building a portfolio that includes assets from differerent asset class, such as cash, fixed-income securities, equities; as well as assets from both Canadian and international markets. Evidence showed that proper asset allocation is more important than picking the top performers.

The basic steps of asset allocation can be illustrated below: .

  1. Identify asset mix - the main asset classes are cash (or money market instruments), fixed income securities, equities, real estate, or precious metals.
  2. Calculate the expected return of return of each asset class, the standard deviation (risk level), and covariance (correlation) among them.
  3. Derive the efficient frontier, the portfolio of assets with the highest level of expected return at any given level of risk.
  4. Choose the optimal asset mix by taking into consideration the financial goals and constraints.
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