Keeping a portfolio with a healthy mix of assets that are properly diversified may allow you to weather market shocks more easily.
2 Tools to Help Keep Your Portfolio on Track
Diversification and asset allocation can be confusing terms. While there are distinct differences, the two definitely intersect in one important way: If you’re a long-term investor, your investing plan would be well-served if you used both asset allocation and diversification as cornerstone principles.
“Asset allocation and diversification don’t protect you from losing money in the short-term,” said Joe Correnti, senior vice president of brokerage product at Scottrade. “But they do provide you with a strategy for helping you reach your long-term investing goals and managing risk in your portfolio. Without them, you might be left with a portfolio that’s not organized to meet your goals.”
So what are asset allocation and diversification, and how should you include them in your portfolio?
By employing asset allocation, you choose a combination of investments for your portfolio, which may include stocks, bonds and cash (or cash equivalents) based on your goals and risk tolerance.
It’s the blend of asset classes that matters most for your investing plan. A more aggressive mix – meaning a higher percentage devoted to stocks than bonds – is likely to produce higher returns over time, but with greater risk of short-term losses. The opposite is also true. A mix tilted more heavily to bonds generally has a lower level of risk, but can be expected to produce lower returns.
Each asset class carries with it varying degrees of expected return and risk and may perform differently from one another over time. Ideally, your asset classes would not be well correlated. That means in Year 1, you might have one asset doing poorly, with another doing well. In Year 2, the situation could reverse itself. In that case, holding multiple types of assets can help smooth out the swings you might experience from holding a single asset class.
Your asset allocation likely will change through life as your tolerance for risk changes. You might change your allocation as you get closer to retirement and need to preserve capital. In that case, you might consider placing a higher concentration of your assets in certain bonds or other fixed-income investments.
“As your tolerance for risk changes, you should consider adjusting your allocation plan,” Correnti said.
Once you’re comfortable with a particular asset allocation, you will have to pick securities for each asset class. Diversification means that you hold a mix of securities within each asset class that vary by industry, sector, geographic location or other differentiating factors. Owning a diverse portfolio of investments is an important way to manage risk.
A security could be any number of things, including a stock, a bond, a real estate investment trust, a certificate of deposit, a mutual fund or an exchange-traded fund.
You could pick a single stock and let the entire stock portion of your portfolio ride with it. That means you would risk everything in that asset class on a single company, which would be an undiversified approach. Or you could select a diversified mutual fund or exchange-traded fund, which might hold dozens or hundreds of securities. That would be a diversified strategy.
Put more simply, diversification means you don’t put all of your eggs in one basket.
”Diversification is not a guarantee against losses, but it can help you better manage and even lower your risk without sacrificing too much in returns,” Correnti said. “When using these strategies, it’s important to review your portfolio periodically and make adjustments, as needed, to stay on track.”
The content provided is for informational and/or educational purposes only. The information presented or discussed is not, and should not be considered, a recommendation or an offer of, or solicitation of an offer by, Scottrade or its affiliates to buy, sell or hold any security or other financial product, or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances, and your investment objectives. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.
Bonds involve risks including, but not limited to interest rate risk, reinvestment risk, inflation risk, call risk, liquidity risk, credit risk, market risk, default risk, event risk, and a risk of loss of principal. New issue offerings are sold by prospectus or offering circular available by contacting Scottrade. Investors should read these carefully.
Investors should consider the investment objectives, charges, expense and unique risk profile of an exchange-traded fund (ETF) or mutual fund before investing. A prospectus contains this and other information about the fund and may be obtained online or by contacting Scottrade. The prospectus should be read carefully before investing.
Diversification may help spread risk, but it does not assure a profit, or protect against loss, in a down market.
More Articles & Insights
Before you can achieve success in your financial portfolio, you should consider setting clearly defined investing goals.
Scottrade Brokerage President Peter deSilva was drawn to the firm by its client-first approach. This approach was demonstrated with the company named “Highest in Investor Satisfaction with Self-Directed Services” by J.D. Power.