How to Use the 5% Rule in Portfolio Management?

What is the 5% portfolio rule?

The 5% portfolio rule advises investors to be cautious about investing more than 5% of their portfolio in any one option. This applies to asset classes, such as stocks, bonds or real estate.

An asset class refers to a group of instruments that share characteristics. These can include stocks, bonds or real estate. Asset allocation involves distributing investments across asset classes within a portfolio. The aim is to optimize risk and return based on an investor's goals and risk tolerance.

Two Ways to Use the 5% Rule of Investing

Utilizing the 5% rule in investing can be achieved through two approaches:

• Buy at least 20 individual stocks: Diversify your investment by purchasing a minimum of 20 different individual stocks.

• Invest in an index fund or diversified ETF (Exchange-Traded Fund): Opt for a more hands-off approach by investing in an index fund or a diversified ETF. These funds consist of a broad range of stocks, mirroring the performance of a specific market index. This method provides instant diversification without the need to individually select and manage multiple stocks.

What assets should be in my portfolio?

In building your portfolio, consider various asset allocation models tailored to different risk and return profiles:

Fixed Income Portfolio:

• Allocation: 100% in bonds.

• Aim: The stress is on capital preservation and generating income through fixed-interest securities.

Income Portfolio:

• Allocation: 70% to 100% in bonds.

• Objective: Focuses on generating a steady income stream, making it suitable for investors seeking regular payouts.

Balanced Portfolio:

• Allocation: 40% to 60% in stocks.

• Goal: Strikes a balance between growth and income, suitable for investors looking for a moderate level of risk.

Growth Portfolio:

• Allocation: 70% to 100% in stocks.

• Purpose: Aims for capital appreciation by investing in growth-oriented assets, suitable for those with a higher risk tolerance.

Additionally, consider the Yield Portfolio:

• Allocation: Varied, with an emphasis on high-yielding assets.

• Purpose: Primarily focuses on investments with attractive yields, making it suitable for investors looking for income generation while maintaining some growth potential.

Selecting the right allocation model depends on your financial goals, risk tolerance, and investment horizon.

Example of balanced portfolio

1. 65% Stocks-

   a

   Blue-Chip Stocks (Large Caps)-

   - 25% Unilever PLC (ULVR)

   - 15% BP plc (BP)

   - 10% GlaxoSmithKline plc (GSK)

   b

   Mid-Cap Stocks-

   - 10% Rolls-Royce Holdings plc (RR)

   - 5% Barratt Developments plc (BDEV)

2. 25% Bonds-

   a

   Government Bonds:

   b

   Corporate Bonds:

   - Vanguard Total Bond Market Index Admiral Shares (VBTLX)

3. 10% Cash or Cash Equivalents-

The cash allocation provides liquidity and flexibility. This balanced portfolio combines a mix of domestic and international stocks (equities) with investment-grade corporate bonds.

For more information on the ETFs we recommend reading - 10 Best ETFs to buy and hold

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Another meaning of the 5 percent rule

The Financial Industry Regulatory Authority (FINRA) enforces the five percent rule, a guideline established in 1943.

This regulation mandates that brokers and brokerage firms should not impose commissions, markups, or markdowns exceeding 5% on standard trades, including both stock exchange listings and over-the-counter transactions. This limit also applies to proceeds from sales and riskless transactions.

Commonly referred to as the FINRA 5% markup policy or simply the 5% policy, it is important to note that this rule serves more as a guideline than a strict regulation. Its primary objective is to ensure that brokers adhere to fair and ethical practices when determining commission rates.

By doing so, the rule aims to guarantee that the prices investors pay are reasonably aligned with the prevailing market conditions for the securities they purchase.