Don’t put all your eggs in one basket. You have no doubt heard this refrain before. As it relates to investments, it is a basic and effective concept that can be easy to lose sight of when narrow parts of the stock market perform particularly well. Diversification entails allocating your investments to many parts of the stock and bond markets so that your risk to any one type of asset category is limited. This practice is designed to help reduce the volatility of your portfolio over time. While it does not ensure a profit or guarantee against a loss, it can help you weather the markets ups and downs. But how do you ensure you have a diversified portfolio that fits your time frame, investment objectives, and risk tolerance?
1. Start with your time frame and investment objective
When investing consider how long it is until you reach your goal (retirement, college, saving for a home, etc.). The longer the time frame, the more risk you can incorporate into your allocation. The two biggest mistakes people tend to make are being overly conservative when they are young or being too aggressive when they are older.
2. Identify your risk tolerance by asking yourself some hard questions
There has been greater and greater acceptance of an emerging field called behavioral finance. At its core, behavioral finance delves into the biases and mistakes we tend to make with money and investments. In that vein, you must honestly evaluate how you think and behave with your investments. Will you check your balance constantly even though your time frame is 30 years? That is not rational but if that is how you will behave then you might consider being more moderate with your risk allocation. The reduced volatility may ease your anxiety and allow you to stay the course when markets are choppy. Alternately, are you a worry wart but will never look at the investment? You may be able to tolerate more risk than you suspect, which allows greater potential for return over a long time frame.
Ultimately, risk tolerance is a squishy concept. You have to evaluate yourself and gauge whether or not you can stick with an investment plan when you experience certain levels of volatility or price movement.
Diversification entails allocating money to US and international stocks, bonds, and cash. The greater your allocation to stocks, the greater the overall risk and potential return. A general rule of thumb on a stock versus bond allocation is 120 – your age = your stock allocation. If you are 40 years old, you would have 120 – 40 = 80% in stocks. Similarly, if you were 20 years old, 100% stocks would be reasonable. This is intended as a jumping off point. You then have to revisit your risk tolerance and behavioral factors.
Once you have identified the stock bond mix you have to evaluate how much exposure you want to small caps, mid-caps, large cap (US and International), emerging markets and other assets. There are any number of tools online to assist you with allocations. You can also use something called a Target Date Fund which most major investment firms offer. While they are imperfect, they do much of the work for you and allow for simple one stop shopping.
Buy low, sell high. Everyone knows that is the goal with investments but it is easier said than done. Reflecting back on behavioral economics, it is difficult to sell something that is performing well. However, that is exactly what selling high involves. Similarly, buying low means allocating money to something that is doing poorly. Investors do not naturally want to do either, even though it is in their best interest.
An easy way to automate this Buy Low, Sell High process is to periodically rebalance the portfolio. That entails taking the allocation back to the original targets. For instance, imagine you had a portfolio that was 50% in stocks and 50% in bonds. During the next year the stocks went up 20% and the bonds earned 0%. At the end of that year, the allocation would be 60% stocks and 40% bonds. Rebalancing simply takes it back to the original 50/50 allocation and forces the investor to sell stocks while they are high and buy bonds while they are low.
Realizing your long-term investment objectives involves balancing risk and reward, diversifying your investments, and periodically rebalancing to ensure you keep risk in check.
This is not a recommendation and is not intended to be taken as a recommendation. This material was prepared for general distribution and is not directed to a specific individual.
LPWM LLC does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisers.