Earlier this week we defined asset classes and talked briefly about how each asset class plays a different role when it comes to your portfolio. Then how and why, you may ask, should I diversify?
Goals of Portfolio Diversification
There are several goals accomplished through portfolio diversification. While it will not necessarily ensure gains or guarantee returns, a diversified portfolio does offer the potential to improve returns over the long term, and perhaps more importantly may reduce portfolio risk, as investments – stocks, bonds, and cash do not move in the same direction at the same time. And with stocks, the stocks of different asset classes, sectors, and countries display different performance characteristics at various points of time.
When considering how your assets should be allocated, it is critical that the combination of stocks, bonds, and cash gives you the best chance to achieve your goals, is appropriate for the time horizon of your specific goals, and aligns with your overall tolerance for risk.
Aligning with Your Risk Profile
The most conservative portfolio is that which would have 100% fixed income or cash holdings. While this type of portfolio may be appropriate for income or liquidity based needs in the very short-term or for an investor who does not have enough of a risk appetite to invest in the equities markets, the downside is that taking too little risk may not provide enough growth potential and might cause you to fall short of your goals.
On the other hand, the most aggressive portfolio is one with all stocks. Over the long-term this may provide the type of growth needed to achieve long-term goals, but one must have a very high risk tolerance and long time horizon to stomach the volatility along the way. Being too risky could cause you to panic when markets correct themselves, and ultimately you might abandon your strategy.
Examples of Risk Profiles
With that being said, the portfolio mix for most investors will fall somewhere in between. Here are some examples:
Moderate Conservative: Best for an investor whose goals are not in the too distant future, may have just a little appetite for risk, but who wants some growth potential. The mix of assets held in this portfolio type is between 25-40% stocks and 60-75% fixed income. While there will be opportunity for some growth, the losses during an unfavorable market period should be considerably less than the overall market.
Moderate: A good asset allocation for an investor with long term goals who can take on a moderate amount of risk. The diversification present in the asset allocation is between 50-60% stocks and 40-50% fixed income. Because of the balanced nature of a moderate portfolio there is good potential for growth and losses are moderated as there is still quite a bit of exposure to fixed income.
Moderate Aggressive: This portfolio allocation is most appropriate for an investor with long-term goals who has a high tolerance for risk and is 70-85% stocks and 15-30% fixed income. Because of the reduced role that fixed income has in this portfolio, the degree of risk is high as is the potential for portfolio growth – however given there is still some bond exposure, a moderate aggressive portfolio is still somewhat less volatile than an all stock, or aggressive portfolio allocation.
Ultimately when determining how much of each stock asset class should be used and what types of fixed income should include a portfolio, you should contact your financial advisor for more specific direction. Your financial advisor will take your goals, timeline, and personal situation into consideration when building a tailored plan that fits your unique needs.