- June 11, 2019
- Posted by General Electric Credit Union
- 6 read
Understanding Diversification and Asset Allocation
When investing, particularly for long-term goals, there are two concepts you will likely hear about over and over again — diversification and asset allocation. So, what is diversification and asset allocation? Understanding how the two work can help you build a portfolio to target your specific needs.
Diversification: Spreading out risk
Diversification refers to the process of investing in a number of different securities to help manage risk. The theory is that if some investments in your portfolio decline in value, others may rise or hold steady.
If you want to invest in stocks, for example, rather than investing in just domestic stocks, you could diversify your portfolio by investing in foreign stocks as well. Or you could choose to include the stocks of different size companies (small-cap, mid-cap, and/or large-cap stocks).
If your primary objective is to invest in bonds for income, you could choose both government and corporate bonds to potentially take advantage of their different risk/return profiles. You might also choose bonds of different maturities because long-term bonds tend to react more dramatically to changes in interest rates than short-term bonds. As interest rates rise, bond prices typically fall.
Asset allocation: Investing strategically
Asset allocation is a strategic approach to diversifying your portfolio among different asset classes that provide the highest potential return within a certain level of risk. After carefully considering: your investment goals, time, and risk tolerance, you would then invest different percentages of your portfolio in targeted asset classes to pursue your goals. A careful analysis of these three personal factors can help you make strategic choices suitable for your needs.
Generally speaking, a large accumulation goal, a high tolerance for risk, and a long-time horizon would typically translate into a more aggressive strategy and therefore a higher allocation to stock/growth investments. One example of an aggressive strategy is: 70% stocks, 20% bonds, and 10% cash.
The opposite is also true, a small accumulation goal (or one geared more toward generating income), a low tolerance for risk, and a shorter time frame might require a more conservative approach. An example of a more conservative, income-oriented strategy is: 50% bonds, 30% stocks, and 20% cash.
Re-balance to stay on target
Over time, an asset allocation can shift simply due to changing market performance. For example, in years when the stock market performs particularly well, a portfolio may become over weighted in stocks. Or in years when bonds outperform, they may end up comprising a larger-than-desired percentage of the portfolio. In these situations, a little re-balancing may be in order.
There are two ways to re-balance. The first is by simply selling securities in the over weighted asset class and directing the proceeds into the under weighted ones. The second method is by directing new investments into the under weighted asset class until the desired allocation is achieved. Keep in mind that selling securities can result in a taxable event, unless they are held in a tax-advantaged account, such as an employer-sponsored retirement plan or an IRA.
"Winning" asset classes over time
The following table shows the number of times in the past 30 years each asset class has come out on top in terms of performance. It helps illustrate why diversifying among asset classes can be important. Bear in mind, however, this table does not reveal the ups and downs experienced along the way. Although stocks in general, and foreign stocks in particular, have come out on top in terms of winning years, the amount of volatility they experience is typically greater, and sometimes far greater, than that of cash and bonds.
Investing in mutual funds
Because mutual funds invest in a mix of securities chosen by a fund manager to pursue the fund's stated objective, they can offer a certain level of "built-in" diversification. For this reason, mutual funds may be an appropriate choice for novice investors or those wishing to take more of a hands-off approach to their portfolios. Including a variety of mutual funds with different objectives and securities in your portfolio will help diversify your holdings much more. You can also select a combination of mutual funds to achieve your portfolio's targeted asset allocation.2
Is your investment portfolio working for you?
Investment Services, provided by CUSO Financial Services, L.P. (CFS),3 can review your current portfolio to ensure you have the right mix of investments to help meet your future needs. Contact Investment Services today at: 513.243.6510 or email Todd Blessing at: todd.bl[email protected] or Erik Waldron at: [email protected].