Effective portfolio diversification helps smooth out investment returns and better manage risk.
One of the most important aspects of successful investing is to have an effective asset allocation strategy. Asset allocation is the process of dividing your investments among the major asset classes, such as equities, fixed income and cash. Traditionally, equities have generated the strongest long-term investment returns, yet they are also the most volatile of the asset classes. Fixed-income securities such as bonds tend to have less volatility, but the trade-off is lower expected returns than equities. While cash and cash equivalents like treasury bills and money market instruments are typically the safest asset class, they also produce the lowest returns over time.
Your ideal asset mix will depend on your investor profile, which takes into account your short- and long-term investment objectives, investing time horizon and risk tolerance level. Effective asset allocation is fundamental to meeting your investing goals.
Which way of investing would help you sleep better at night?
Why asset mix is so important - an example
Let's say you owned three mutual funds in the same asset class and with similar investment management styles. As you can see in the first chart, your funds will rise and fall in a similar pattern, giving you little protection from the ups and downs of the market (i.e., volatility).
The second chart shows how funds in different asset classes and with different management styles – such as an aggressive global equity fund and a conservative bond fund – can help reduce overall volatility in your portfolio. The two wavy lines represent the two funds, while the solid line shows the smoothed-out combined return of these funds.
The power of diversification
Diversification is also crucial to your long-term investing success. Not only does it involve spreading your investments among different asset classes, but it goes a step further and results in a portfolio mix that reflects different geographic regions (e.g., North America, Europe, Asia, emerging markets), investment management styles (e.g., growth or value) and market capitalizations (e.g., large-, medium- or small-sized companies).
When you diversify along these lines, you can manage your portfolio risk better and reduce your exposure to market volatility. Investing in mutual funds can offer you the many benefits of proper diversification. Mutual funds are professionally managed using various asset classes and investment styles and invest in a well-diversified range of securities that would be difficult for most individuals to replicate on their own.
Your financial advisor can help you diversify your investment portfolio across the appropriate assets so you have the right blend of growth potential, income and liquidity (i.e., access to your money), with a level of risk that is in line with your investor profile. Your advisor can also rebalance your portfolio at regular intervals to ensure that it remains aligned with your long-term objectives.
The contents of this Web site are provided for informational and educational purposes, and are not intended to provide specific individual advice including, without limitation, investment, financial, legal, accounting or tax. Please consult with your own professional advisor on your particular circumstances.