This article appeared first on The Stock Market Blueprint Blog.
In a previous post, we discussed four simple steps to help you create your own investment strategy. The four steps in that post were:
- Select the Stock Screen You Want to Follow
- Choose How Many Stocks You Will Own
- Determine How Much of Each Stock You Will Own
- Set Buy and Sell Rules
Equal-Weight Your Portfolio
When addressing the best way to determine how much of each stock you will own, we stated in the first post that equal-weighting a portfolio is the way to go.
The simplest and most effective allocation method for individual investors is an equal-weighted portfolio. This means you invest the same amount into each stock.
For example, if you have $10,000 and you want to own 10 stocks, simply invest $1,000 in each stock you buy.
What exactly is an equal-weight portfolio and how does it compare to the alternatives?
Best Allocation Method
Equally weighting a portfolio is a type of allocation method. Typically, the term “asset allocation” is mistakenly used when discussing asset class allocation.
In its strictest sense, asset allocation really refers to specific assets, such as individual stocks. In this case, how much money will you allocate to each stock that you own?
It’s helpful to follow a set of allocation principles when building a common stock portfolio. Investors who do not follow a set of predetermined guidelines must guess how much to invest in one stock over another.
Alternative Allocation Methods
There are an infinite number of allocation strategies to choose from.
For example, the Dow Jones Industrial Average (DJIA) weights, i.e. allocates, stocks by share price. The S&P 500 uses market capitalization to weight stocks.
Additionally, several ETFs and mutual funds have become very creative in their allocation approaches. Some funds allocate stocks based on a stock’s valuation. While others weight based on a company’s sales. The options are limitless.
Individual investors would be wise to avoid using the allocation methods of the DJIA and S&P 500. Weighting stocks based on share price is arbitrary and has no positive effect on total returns.
Meanwhile, market-cap weighting, which buys more shares of higher priced companies and less shares of companies with lower valuations, will most likely negatively impact overall returns.
Simple and Intuitive
Equal-weighting a portfolio is not only the most simple allocation method, it also makes intuitive sense.
When you invest the same amount of money into each stock, you are inherently buying more shares of undervalued companies. Consequently, you’re buying less shares of higher-valued companies.
Mitchell Mauer is the Founder of TheStockMarketBlueprint.com. The Stock Market Blueprint is a site that finds value stocks for investors building long-term wealth. The site’s investment philosophy is anchored in principles established by Benjamin Graham and his most reputable followers over the last 100 years.