If your investment portfolio can’t withstand volatile financial markets, it may not be diversified enough. The well-worn saying; ‘don’t put all your eggs in one basket’ is particularly well suited to investing. Unfortunately, many investors fail to heed this advice.
A well thought-out, long-term investment strategy involving not just one or two investments, but a mix of different types of securities is what we call asset allocation.
Asset allocation helps protect your investments against downturns, and tailors the level of risk in your portfolio to your individual needs. In fact, diversification is the single most important element of investment success.
Different types of assets do well during different phases of market cycles. With a balanced portfolio, a decline in one asset class may have less effect on your overall investment returns.
Diversification means not only holding funds in various market sectors, but also in different areas of the world. Cycles in various world markets do not always move in tandem with each other, so there are usually investment opportunities somewhere. It is important to choose the right mix, consistent with your own personal tolerance for risk.
There are a few basic steps to formulating an effective asset allocation strategy.
- Define your financial goals and the length of time you have to achieve those goals.
- Consider how comfortable you are with investment risk — for example, will you lose sleep over stock market investments that move up and down in value?
- Create a balanced portfolio with a mix of investments from the major asset classes and markets. A financial advisor can help you choose a portfolio that suits your needs and goals.
- Adjust your portfolio mix as you move through life. When you’re younger, you may want to concentrate on equities to build wealth. As you approach retirement, you may wish to preserve the wealth you’ve accumulated through a greater concentration of lower-risk, fixed-income assets.
- Develop a geographical allocation as well as an asset allocation strategy to benefit from emerging markets such as Eastern Europe, Russia, and Latin America as well as more traditional markets.
Diversifying your portfolio
So how do you diversify your portfolio? You should have a mix of investments from different asset categories including cash, fixed-income, and equities. Equities and mutual funds that contain equities experience price fluctuations while fixed-income investments generally produce steady, interest-based returns with little risk. You need exposure to global markets and to not rely on the old favorites; growth comes from innovation, and that usually means emerging economies.
There is a trade off, however. The greater the potential for greater long-term gains, the greater the volatility.
The performance of financial markets also varies. While one stock market is on the rise, those in other areas of the world may be in decline. When stock markets are strong, bond markets may be weak. Through the asset allocation process, you can use these variations in performance to your advantage.