We continue with the second of a two-part series outlining the most important investing concepts to know on your way towards planning for your financial future. In part 1, we discussed asset allocation and the different asset classes available to you as an investor. Today we’ll be talking about how diversification helps in asset allocation decisions.
Diversification– Don’t Put All Your Eggs In One Basket
Stocks, bonds and cash are the major asset categories, and it is the way these asset classes are combined (your asset allocation) that is the biggest determinant of your portfolio’s return.
Modern Portfolio Theory tells us that combining asset classes that do not move in tandem reduces risk. Investments behave differently. Some tend to move up or down in value together. Others move independently of each other or move inversely (when one is up the other is down). While we would all like to own investments that only go up, we know that this is unlikely to occur. So the way to protect your investments is to not “put all your eggs in one basket” and instead own a mix of asset classes that perform differently from one another.
You can start with a mix of stocks and bonds. That will immediately reduce your risk versus a portfolio of, say, only stocks, or, God forbid, one stock. But there is even more opportunity to diversify within stocks and bonds. Ideally, you would invest in large company stocks, small company stocks, international stocks and even emerging markets stocks. These sub-asset classes are not perfectly correlated, and one may do well when another does not. You would not want own only U.S. large company stocks (so-called blue chips) when emerging markets or small cap stocks are outperforming, as they often do. Similarly, you’d be in for a bumpy ride if you owned only emerging markets stocks.
On the bond side, you might diversify by investing in highly rated (credit safe) bonds, high yield bonds, non-U.S. bonds and bonds from emerging markets. Within those categories would be further diversification by including government and corporate bonds as well as mortgages.
Your Asset Allocation
So how do you combine all of these asset classes and sub-asset classes into an allocation that is right for you? Before deciding, you must first consider your financial goals. Will this portfolio be focused on helping you retire? When do you plan on retiring? This is also called your time horizon, or the length of time that you can invest. What is your need for income and your tax situation?
Your hoped for return requirements and tolerance for risk will also play into determining what is the appropriate allocation for you. The proportion of each asset class in your portfolio will determine both the expected return and the expected risk of your investment. More on that coming later this month—for now, remember the important concept of broad diversification across asset classes as the building block for your portfolio.
