Become a savvy investor – What’s in your basket?

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.

Hewins Financial Advisors, LLC d/b/a Wipfli Hewins Investment Advisors, LLC (“Hewins”) is an investment advisor registered with the U.S. Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940. Hewins is a proud affiliate of Wipfli LLP. Information pertaining to Hewins’ advisory operations, services and fees is set forth in Hewins’ current Form ADV Part 2A brochure, copies of which are available upon request at no cost or at www.adviserinfo.sec.gov. The views expressed by the author are the author’s alone and do not necessarily represent the views of Hewins or its affiliates. The information contained in any third-party resource cited herein is not owned or controlled by Hewins, and Hewins does not guarantee the accuracy or reliability of any information that may be found in such resources. Links to any third-party resource are provided as a courtesy for reference only and are not intended to be, and do not act as, an endorsement by Hewins of the third party or any of its content or use of its content. The standard information provided in this blog is for general purposes only and should not be construed as, or used as a substitute for, financial, investment or other professional advice. If you have questions regarding your financial situation, you should consult your financial planner, investment advisor, attorney or other professional.
OneBite Editorial Staff
OneBite Editorial Staff

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Become a savvy investor – What’s in your basket?

time to read: 2 min