The main challenge you face as an investor is earning the return you want while managing the risk involved. Here's where diversification is crucial. Keeping a diverse portfolio means spreading your investments among different classes of assets (e.g., stocks, bonds and cash equivalents), so that they work together to build your wealth, while affording you some protection from downturns in any specific asset class.
The process of balancing asset classes in a portfolio - determining what percentage should be placed in cash, what percentage in bonds and what percentage in stocks - is called asset allocation. Asset allocation may account for the success of your portfolio more than the specific securities you hold, and even more than the timing of your buy and sell decisions.
Diversification involves dividing your investments across and within a variety of asset categories (e.g., stocks, bonds and cash equivalents). If there is a downturn in any one market, this practice can help you manage risk.
Each asset category offers different types of risks and rewards; each category is also affected differently by economic events. Investments across different asset categories, therefore, gain and lose ground independently. This protects you from losing your entire portfolio should one investment significantly underperform, or even lose all its value. In addition, large fluctuations are often balanced out. For example, if one of your stocks lost significant ground, chances are that in a diversified portfolio you would hold two or three bonds that would balance the loss with predictable income.
Similarly, you can diversify within categories. A rise in a utility stock might cancel out a loss in a tech stock; your investment in a municipal bond could make up for underperformance in a corporate bond, and so on.
There are two specific types of risk to keep in mind when investing: unsystematic risk and systematic risk.
- Unsystematic Risk
Risk that applies only to a specific company. Examples could be as routine as poor sales or as dramatic as an office fire. This is one of the reasons why it is unwise to "put all your eggs in one basket;" there is little chance that these events would occur to every company in a diversified portfolio at the same time.
- Systematic Risk
This type of risk, however, can affect all the companies in your portfolio at the same time. Rising interest rates, inflation, wars, and political changes influence the whole economy, not just one company. It is virtually impossible to avoid these events.
Bear in mind that diversification may also reduce the return of your portfolio. This happens because the overall return on your portfolio will be the average return on all your investments. For example, if one of your stocks had a total return of 24% and one of your bonds had a return of 8%, the total portfolio return between the two would be 16% = 32% ÷ 2. If your entire portfolio had consisted of that stock, it would have yielded a return of 24% instead of 16%.
Naturally, the reverse would hold true if the stock lost 24%.
Although diversification may lessen the potential returns of market highs, it may also reduce the effects of potential lows. It may also help protect against risk and market volatility.
The process of balancing asset classes in a portfolio - determining what percentage should be placed in cash, what percentage in bonds and what percentage in stocks - is called asset allocation. How you allocate your assets depends on your individual needs, your investment time frame, your risk tolerance and other situational factors.
Several factors may influence the amount of risk you can comfortably accept in your portfolio:
- Your age
- Family situation
- Income, and
- Financial goals
Balanced portfolios contain assets allocated across a range of investments. Individual needs may vary; as such, a well-balanced portfolio depends greatly on your particular situation. There is no specific example of a portfolio that is "correct." A portfolio that is not balanced, however, may not deliver maximum value. It may even subject you to unnecessary risks.
Since the markets evolve and your personal goals will inevitably change with time, one of the best ways to keep your investments on target is to meet regularly with your financial professional to discuss ways to keep your investments on track. He or she can help you determine an asset allocation that is appropriate based on your personal situation and reflects current market conditions.
A long-term investment strategy does not imply a passive "invest-and-forget" approach. Once your asset allocation is set, you should periodically review it. Your portfolio will need rebalancing over time because:
Your Investment Objectives or Personal Circumstances Can Change
A change in your household's income may lead to an adjustment in the amount you earmark for investing. If you receive a raise or a bonus, you might use the extra income to implement a more aggressive asset allocation. In such a case, your asset allocation could increase the percentage you hold in stocks.
Another factor that could throw your asset allocation off track is a family change. The birth of a child will probably make you start thinking about starting a long-term education savings plan, something that might not already be in your asset allocation.
A child's graduation from college may be another reason to rebalance your portfolio. The elimination of tuition bills might let you add more to your investment program and focus on other goals such as retirement. The allocation you maintained yesterday, when you were building capital for retirement, might not be right when you retire and need a steady and sustainable stream of income.
Your Investments May Grow at Variable Rates, Changing the Balance of the Asset Allocation
As the economy moves through each stage of its respective cycle, some investments will perform better than others. For example, an expanding economy may create healthy corporate profits and rising stock prices, but a corresponding rise in interest rates may put a damper on bond prices.
- If your stock holdings rise above your original allocation, your risk exposure increases.
- If your stock holdings fall below their target, your future growth potential may be lower.
Therefore, over time, the very nature of the market can throw your asset allocation out of balance. Suppose you decided upon a 60/40 mix of stocks and bonds for your asset allocation. After some time, the potential overall increase in stock prices might increase the value of the stocks in your portfolio, thus changing your stock/bond mix to 70/30.
Knowing when to rebalance is half the battle; knowing how to rebalance is the other. One way to rebalance is to increase your investment in asset categories that have fallen below your original allocation percentages. Another is to sell assets in one category and use that money to increase your investment in categories that have become underweighted.
Before you decide which will be the best method for you to rebalance your assets, there are several steps you should take:
- Review your most recent account statements. (Be sure to include tax-deferred investments, such as 401(k) and individual retirement accounts.)
- Determine the total dollar value of each investment by category and then what percentage of the total is invested in each category.
- Compare these figures to your original asset allocation, to see where your portfolio has changed.
- Consult your financial professional regarding the best ways to rebalance your portfolio.