Constructing a proper portfolio includes consideration of a host of variables including your timeline, objectives and risk tolerance. Many Web sites, self-help writers and online calculators support this concept with simplified strategies that strengthen the notion that individuals can do it themselves. The danger is that many of you believe that implementing simplified, cookie-cutter strategies is all you need to do. Worse yet, your interest in diversification is often driven by your wish to increase investment returns rather than to control risk.
Considering the big picture, I have to agree that if each investor took these variables into account and completed an online allocation, individual investment results would probably improve — and that’s a good thing. However, I maintain that although understanding these variables is necessary, it is by no means enough. I suggest that individual investors consider that a deeper understanding of allocation and diversification strategies can more importantly reduce their downside risk, and thereby increase your return.
I understand this is a fine distinction, but when taken seriously, can help a retail investor think more like an institutional investor. That means thinking long-term, reducing risk and making investment decisions based on a strategy rather than emotion.
Let’s dig a little deeper to better understand this concept.
Asset allocation is the process of dividing a portfolio among major asset categories such as bonds, stocks or cash. The purpose of asset allocation is to reduce risk, not increase returns. The ideal asset allocation differs based on the risk tolerance of each investor. For example: A 30-year-old investor may decide that a allocation strategy including 80 percent stocks, 19 percent bonds and 1 percent cash is appropriate. That investor’s 62-year-old boss may, however, determine that his or her allocation should be just 20 percent stocks, 65 percent bonds and 15 percent cash. Each allocation may be perfectly suited to each investor, but it’s likely the total returns will not be the same.
Diversification represents a risk-management technique that mixes a wide variety of investments within a portfolio. It’s designed to minimize the impact of any one security on overall portfolio performance. Diversification, in fact, is possibly the greatest way to reduce your risk. Our ability to diversify a portfolio has been simplified with the development of mutual funds which, by design, offer greater diversification for the average investor. However, purchasing just one mutual fund provides a certain level of diversification, but falls short of our need for asset allocation. This includes indexed funds. Similarly purchasing one type of stock and one type of bond, leaving a few dollars in cash, is a very simple allocation strategy, but it also falls short of proper diversification.
In order to develop a proper portfolio we need to incorporate both strategies. So although the terms asset allocation and diversification are often used interchangeably, we need to understand they are very different strategies. Once we understand this distinction at a fundamental level we can begin to develop more complex strategies which may provide additional risk protection.
I believe, as a competent financial planner, I must to the best of my ability protect my clients from risk whenever possible and within each client’s tolerance. I develop portfolios incorporating multiple investment vehicles. For example, I may recommend minimizing the use of a 401(k), incorporating a Roth IRA and cash-value life insurance. This strategy provides additional diversification through individual vehicles. The benefit is that each of these vehicles has unique tax characteristics, differing levels of liquidity and long-term opportunities. Then within those vehicles we develop appropriate asset and diversification models for your investments.
Whether you’re just starting out or near retirement, no one vehicle will protect you from all the associated investment risks. But with a mix of properly diversified vehicles, diversification of your investments and a well-developed asset allocation, I can help to reduce additional risks not normally considered in simplified do-it-yourself investment strategies.
Diversification and asset allocation do not guarantee against loss; these methods are used to help manage risk.
Stephen Bossio is the principal of Magnum Financial and the host of Strategies for Creating Wealth live Friday’s from 2-3pm on KSVY Sonoma, 91.3 FM. He welcomes your questions and comments. Stephen can be reached by phone at 707-996-9664 or via email at sbossio@sammonsrep.com. Stephen offers securities through Sammons Securities Company, LLC Member NASD and SIPC. |
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