For many people, investing typically begins with one stock, bond, or mutual fund. Other selections are added over time, because most people understand it is imprudent to invest everything in a single security or fund, even if it has a solid reputation. However, just “spreading money around” in a haphazard way may only create the illusion of diversification.
If you have assembled what is known as a “hodgepodge” portfolio, you may be unaware of the extent to which your investments are (or are not) consistent with your objectives. How do you set up a framework that tailors your investments to your particular circumstances?
Plotting Your Course
A sound portfolio management strategy begins with asset allocation—that is, dividing your investments among the major asset categories of equities, bonds, and cash. You can then make finer distinctions within each broad category. For example, within the equity category, you could diversify among large company stocks, small company stocks, international stocks, and an extensive range of funds. Within the bond category you could separate short-term and long-term bond investments as well as international and domestic.
Since various investment categories have unique characteristics, they rarely rise or fall at the same time. Consequently, combining different asset classes can help reduce risk and improve a portfolio’s overall return. Still, two nagging questions remain: What factors guide the asset allocation process? How much of your portfolio should go into each category?
Getting to Know You. . .
The main objective of asset allocation is to match the investment characteristics of the various investment categories to the most important aspects of your personal investment profile—your risk tolerance, your return and liquidity needs, and your time horizon.
Investing according to your risk tolerance will help keep you from abandoning your investment plan during times of market turbulence. One way to assess your risk comfort zone is to ask yourself how much loss you could withstand in a one-year period and still stay the course. Finding the appropriate level means balancing your risk tolerance against the different levels of volatility of the various asset classes. For example, low risk tolerance may dictate a portfolio that emphasizes conservative investments while sacrificing the potentially higher returns that usually involve a greater degree of risk.
Return refers to the income and/or growth you expect a portfolio to generate in order to meet your objectives. For example, retirees may prefer a portfolio that emphasizes current income, while younger investors may wish to concentrate on potential growth.
Your personal time horizon extends from when you implement an investment strategy until you need to begin withdrawing money from your portfolio. For example, a short time horizon (less than five years) is probably best served by a conservative portfolio emphasizing principal protection. On the other hand, the more time you have to invest, the greater the risk you may be able to shoulder, because you have time to recover from market downturns.
Your Final Destination
How much of your portfolio should go into each category? Asset allocation is more of a personal process than a strategy based on a set formula. Although guidelines do exist to help establish the general framework of a well-diversified portfolio (for example, the need for growth in order to offset the erosion of purchasing power caused by inflation), building an investment portfolio that is right for you involves matching the risk-return tradeoffs of various asset classes to your unique investment profile.