Managing Risk with a Strong Foundation
Asset allocation and diversification are so fundamental that you might consider them the foundation for constructing your portfolio. And just as the foundation of a building may seem to disappear under the finished building, it’s easy to lose sight of portfolio structure as you track the performance of specific securities or the dollar value of your investments.
It might be worth the time to consider how these strategies apply to your investment portfolio. Keep in mind that asset allocation and diversification do not guarantee a profit or protect against investment loss; they are methods used to help manage investment risk.
The Big Picture
Asset allocation generally refers to the mix of three major asset types — stocks, bonds, and cash alternatives — that tend to perform differently under different market conditions. Stocks may have higher long-term growth potential but are associated with greater volatility, while bonds tend to have moderate growth potential with less volatility. Cash alternatives typically have low growth potential but are the most stable of the three asset classes; however, if cash investments do not keep pace with inflation, they could lose purchasing power over time.
The appropriate allocation depends on your age, risk tolerance, time horizon, and specific goals. Younger investors might be comfortable with a more aggressive allocation heavily weighted toward stocks, because they have a longer time to recover from potential losses and may be willing to accept greater risk in exchange for long-term growth potential. Older investors who are more concerned with preserving principal and those with short-term investment objectives, such as college funding, might prefer a more conservative allocation with greater emphasis on bonds and cash alternatives.
Filling In the Details
Diversification refers to the strategy of holding different types of securities within an asset class in order to help spread the risk within that class. For example, the stock portion of a portfolio could be diversified based on company size or capitalization (large cap, mid cap, and small cap). You might also add international stocks, which tend to perform differently than domestic stocks.
A portfolio’s bond allocation could be diversified with bonds of different types and maturities. Corporate bonds typically pay higher interest rates than government bonds with similar maturities, but they are associated with a higher degree of risk. U.S. Treasury bonds are guaranteed by the federal government as to the timely payment of principal and interest. Foreign bonds could also increase diversification. Longer-term bonds of all types tend to be more sensitive to interest rates but typically offer higher yields than bonds with shorter maturities.
The principal value of stocks and bonds fluctuate with changes in market conditions. Shares of stock, when sold, and individual bonds redeemed prior to maturity may be worth more or less than their original cost. Investing internationally involves additional risks, such as differences in financial reporting, currency exchange risk, and economic and political risk unique to the specific country or region. The principal value of cash alternatives may be subject to market fluctuations, liquidity issues, and credit risk; it is possible to lose money with this type of investment.