In this article we will explore the basics of Portfolio Allocation. In simple words, Portfolio Allocation is how you distribute your investments across different assets like cash, mutual funds, stocks, futures, options and other assets. A person with a higher risk tolerance would invest more in stocks, futures and options while someone with low risk tolerance would invest in more income-generating mutual funds.
This article will focus on Portfolio Allocation from a trader’s perspective. Firstly, as a trader it is always important how you are distributing your investment across stocks, futures and options. Futures and Options (F&O) are considered to be a speculative investment because both the profits and losses can be huge in general (and much more than the amount invested). To understand the risks, read this beginner’s article on Futures. It is generally a good idea to decide the percentage of your portfolio that you want to allocate towards speculative assets like F&O and even more important to ensure that it doesn’t grow beyond a certain percentage of your portfolio. Many novice traders get into trading F&O without understanding the risks behind futures and options, and when they start making money, they forget about money management principles and expose too much of their portfolio to speculation.
Let us say you decided to distribute your portfolio into 20% F&O, 60% stocks and 20% cash. Now, if the F&O part of your portfolio were to actually double, it makes sense to liquidate some of your futures and options if you want to manage your risk. Of course the exact exits need to be decided based on Technical Analysis, but it is always a good idea to tighten the targets and stop losses when you want to trim your allocation in one asset. I have seen many novices get into futures or options and after their portfolio gained a lot, did not bother to take profits out of greed and lost out in the end, sometimes, unfortunately, deciding never to trade again. Rather than that, if you are a beginner, it is always best to start with stocks and then slowly venture into other speculative assets like futures and options where the risk is much higher.
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