In my last couple of columns, I told you about two different portfolios that I’ve been running, both of which contain dividend stocks and have been performing very strongly.

That prompted some of you to write in asking what differentiates these two portfolios. It’s a great question and it raises the bigger issue of how you can tweak your own portfolio to better suit your goals and individual tolerance for risk.

The most important difference between the portfolios I’ve been telling you about lately, and something you should carefully consider for yourself, is asset allocation— the broad types and proportions of investments being held in a particular portfolio.

Take my Dividend Superstars portfolio. It contains only dividend stocks (and cash on the sidelines), and I never plan on adding any other type of investments to it.

Meanwhile, my Dad’s Income Portfolio — though currently invested only in dividend stocks and cash — WILL contain other types of income investments as I continue to build it out. For example, I will consider preferred shares, bonds, and other income-oriented mutual funds.

Why Is Asset Allocation So Important?

Because countless studies have demonstrated that it is the #1 factor in a portfolio’s overall long-term performance and behavior. In fact, it is far more important than even the specific investments bought and sold!

What this means is that your first step toward building a better portfolio is not figuring out what particular stock or bond to buy, but rather how much of your nest egg should be invested in each of these particular asset classes (plus others such as real estate and commodities).

How can you decide this?

Well, your desired asset allocation changes over time based on your age and needs. So consider where you’re at in your life right now and go from there.

For example, a younger investor might choose to hold 80 percent in stocks because there’s plenty of time to ride out the greater volatility that comes with this particular asset class. Meanwhile, a retired investor might choose to put far more money in bonds and cash for greater liquidity.

This is precisely why many financial advisers cite the following rule of thumb: “Take 100 and subtract your age. The result is how much you should put in stocks.”

Do I think it’s that simple? Hardly. But the basic idea is sound.

And to circle back, this explains the difference in my two portfolios. Dividend Superstars is meant to be a self-contained list of solid income stocks that can be used for a wide range of investors and purposes — largely depending on what other investments they might own. Dad’s Income Portfolio is designed specifically for my 63-year-old father and other conservative, income-starved investors.

Of Course, Asset Allocation Is Just
The First Step in Building a Better Portfolio …

Don’t get the wrong idea: While asset allocation might be the most important aspect of customizing your own portfolio, I think you absolutely must pay attention to the specific investments you use within those asset classes as well!

For starters, even if you’ve decided to put 80 percent in stocks and 20 percent in bonds, you may favor different categories within those asset classes depending on current conditions.

Examples?

Well, you might want to hold corporate bonds rather than Treasuries right now. Or put more money into utility stocks rather than tech shares.

At the company-specific level, you could favor a bond from General Electric over one from General Motors.

And even if you’re largely a set-it-and-forget-it investor using index mutual funds or ETFs, you could choose the S&P 500 fund from Vanguard over one from T. Rowe Price based on criteria like expense ratios.

One Other Thing to Watch Out For: Investment Overlap

While the ideal scenario is building a portfolio from the ground up — like I’m doing right now — the reality is that most investors have amassed a “collection” of investments over many years or even decades. They may have accounts at multiple brokerages and with different employee retirement plans, too.

The end result is that it’s a lot harder to figure out asset allocations and even the exact proportions of specific investments they own!

Consider someone who holds individual stocks in a brokerage account and then mutual funds in a retirement plan. Unless they’re paying careful attention, one of their stock mutual funds could easily be holding a large amount of a stock they already own individually. The end result is potentially too much exposure to one single investment. Likewise, the same risk exists even with different mutual funds or ETFs.

So, with all that said, here are …

Four Simple Steps to Perform a Portfolio Tune-Up!

First, look for ways to consolidate your accounts wherever possible. That will make it easier to keep track of things going forward.

Second, do a quick inventory of all the assets you currently own and figure out what your current asset allocation is. Decide whether this is where you want to be right now.

Third, if you’ve got a mix of funds and individual holdings, do your best to determine whether you’re too exposed to one particular investment. You can generally get a good feel for what investments are inside ETFs by visiting their company websites. Mutual funds aren’t quite as transparent, but they do post their holdings on a quarterly basis.

Fourth, also look for long-standing losing positions that might be cut now and used for tax advantages, as well as investments that may no longer suit your current risk tolerance and goals.

With the end of the year rapidly approaching, this is the ideal time to take a step back and re-evaluate your overall portfolio. And in just an afternoon’s time, and with a little bit of planning, I guarantee you can find ways to improve your overall portfolio’s performance for 2011 and beyond!

Best wishes,

Nilus

P.S. You can get more information on my Dividend Superstars portfolio by clicking here. And for more details on Dad’s Income Portfolio, just click here.

Related posts:

1. Portfolio Pandemonium!
2. How to Cut the Risk in Your Portfolio
3. Dad’s Income Portfolio

Read more here:
Four Steps to Fine-Tune Your Portfolio