Most of us are familiar with the expression, “Don’t put all your eggs in one basket.” Yet individuals who invested heavily in technology stocks in the late 1990s did just that. Many investors lost substantial portions of their assets when the stock market bubble burst and concentrated positions in the highly valued stocks declined significantly.
On the other end of the spectrum, risk-averse investors who place all of their money in conservative investments, such as bonds and cash, miss out on the long-term growth potential of stocks that can help protect their portfolios against inflation. The asset allocation process, or investment diversification across asset classes, determines approximately 90 percent of investment performance and is the crucial factor for portfolio success, according to a widely recognized academic study.
The asset allocation development process begins by determining the investor’s time horizon, investment goals, current assets and tolerance for risk. Based upon these parameters, target portfolio percentages are assigned to stocks, bonds and cash. Next, asset class allocations are made within each general category based upon expected risk and return characteristics, and correlation, or the relationships between the asset classes. Each of these asset classes can be diversified to include different types of investments, including the combination of growth and value stocks, small-, mid- and large-capitalization stocks, international equity, and government, municipal and corporate bonds. Large portfolios with longer time horizons and higher risk-tolerance may consider alternative asset classes such as high-yield bonds, real estate or private equity. Finally, the investor and financial advisor should determine the appropriate portfolio implementation.
Although most professionals agree that diversification is desirable, portfolio efficiency is predicated upon effective diversification. Greater diversification through added securities or asset classes does not always improve portfolio results—and can actually hinder the portfolio. Improving investment results depends upon building diversified and efficient portfolios. Through a careful analysis, your financial advisor can help recommend an appropriate mix of asset classes designed for your objectives. iBi