Your Portfolio Is Too Risky

Crafting a rewarding portfolio is tough stuff -- so tough that even we Fool analysts can't agree on how to do it.

Don't believe me? I know one Fool who invests solely in biotech stocks! Some of us agree with Wharton Professor Jeremy Siegel, who advocates putting up to 40% of your portfolio in international stocks. Another Fool has almost 20% of his portfolio in one stock. Me? I'm overweighted in small caps such as Buffalo Wild Wings (NASDAQ:BWLD).

We all have different financial goals, areas of expertise, risk tolerances, and retirement timelines. What's right for me -- or my colleagues -- almost certainly isn't right for you. However, there are some general guidelines you can follow to stay out of trouble.

Tip 1: Timing is everything
Money you'll need in the near term shouldn't be in stocks. Stocks outperform bonds over the long term, but they're also much more volatile in the short term. Even blue chips suffer setbacks. For example, solid companies FedEx (NYSE:FDX) and Pfizer (NYSE:PFE) -- both dividend-paying large caps -- are down about 30% since this time last year. Funds you'll need in the next five to 10 years should be in the bank or in bonds, depending on when you'll need to use them.

Tip 2: Don't buy anything you don't understand
If you don't understand it, don't buy it. The housing bubble happened because people didn't comprehend the downside risk of the inflated homes they were buying or the exotic loans they were using to finance them. They focused only on the upside -- and you know how that turned out.

Do you understand the complex derivative instruments that Goldman Sachs (NYSE:GS) and Blackstone (NYSE:BX) use to make their money? Similarly, do you understand how pipelines and patents will affect the future of a biotech such as Celgene (NASDAQ:CELG)? If not, there's nothing wrong with passing up complicated stocks in favor of an investment vehicle you can understand. The SPDRs (AMEX:SPY) exchange-traded fund is a good, low-cost option, for example. There's also nothing wrong with putting money into a mutual fund. In fact, the great majority of us would be better off if we did just that.

Tip 3: Diversify away your losses
Despite the examples of my colleagues, you probably shouldn't put all of your money in biotechs or a fifth of your portfolio in one stock. The folks mentioned above have extremely high risk tolerances -- and they pick stocks for a living. People may warn you against "diversifying away your returns," but unless you're Warren Buffett, you're better off not investing too much in one company, sector, country, or type of investment.

Take a look at this table of average returns from 1972 to 2004.

Source: Motley Fool Rule Your Retirement.

The balanced portfolio, which included equal amounts of the four asset classes, rebalanced annually, had returns nearly as good as the best-performing asset -- with much lower volatility.

Since we can't predict how different asset classes, industries, companies, or countries will perform going forward, smart diversification can help you maximize the upside while you minimize the downside.

The Foolish bottom line
There are as many ways to construct a portfolio as there are investors -- but a few rules of thumb can still help you keep all of those portfolios solvent.

Robert Brokamp and his team at the Motley Fool Rule Your Retirement service have many rules of thumb to help you retire in style -- including model portfolio allocations. A 30-day free trial gives you access to all past issues, as well as retirement calculators, interviews with other experts, and tips for locating, as well as allocating, your assets. Click here to get started -- there's no obligation to subscribe.

Anand Chokkavelu refuses to understand anything he doesn't buy. He owns shares in Buffalo Wild Wings, which is a Motley Fool Hidden Gems recommendation. Pfizer is an Income Investor and Inside Value pick. FedEx is a Stock Advisor selection. The Fool owns shares of Buffalo Wild Wings and SPDRs. The Motley Fool has a disclosure policy.