Dear Readers: Here we go again. In early March, the COVID-19 pandemic brought the 11-year bull market to a crashing halt. Since that time, the markets have largely recovered but been plagued with extreme volatility, leaving individual investors frightened and confused. While every investor knows that risk comes with the territory, the recent wild gyrations are enough to make even the hardiest investors feel unsure.
So it comes as no surprise that Im getting a lot of questions about how to protect a portfolio. People want to know if the standard advice has changed. The good news is that even though some points of execution have been fine-tuned, the fundamental principles of asset allocation and diversification remain the best ways to control risk. Lets take a look.
Asset Allocation and Diversification: Still the Best Investment Strategy
Asset allocation and diversification seem pretty similar, and a lot of folks confuse the two, but theyre actually quite different. A key to creating a sound investment portfolio is to understand that difference and how the two work together.
Asset allocation is the way you divide your money among major investment categories like stocks, bonds, cash and other types of investments, some of which are riskier than others. Therefore, this division into the various asset classes should be based on how much risk youre comfortable taking and how soon youll need your money.
While stocks have the highest return potential, they also carry the highest short-term risk. Cash, on the other hand, has the lowest return potential but the least amount of short-term risk. Bonds are somewhere in between. Any money youll need within the next three to five years should be kept in lower-risk investments.
Asset allocation was first introduced as a way to manage risk in the 1950s. Research showed that a portfolios overall risk and expected return was a result of how each underlying investment performed individually as well as how investments behaved together. By choosing a variety of investments that react differently to market conditions—or those that have a low correlation to each other—an investor could reduce overall risk.
Diversification takes this concept a step further by spreading your money between different types of investments within each asset class. For instance, instead of one stock or bond, ideally, you would have many. Dividing even further, you should have different types of stocks, such as large-cap, small-cap and international.
And within those divisions, you can diversify further by investing in different sectors (i.e. technology, health care, telecommunications) and different industries within the sectors. In the case of bonds, you can diversify within government, government agency, corporate, international and high-yield (“junk”) bonds of different maturities.
Your ultimate goal is to find investments that dont move in lockstep with one another. That way, when one investment goes through a rough patch, another will hopefully compensate.
You might say that asset allocation lays the foundation for your portfolio and diversification builds the floors and rooms. With the two working together, you have greater opportunity for your investments to perform differently under various market conditions. One investment might go up when the other goes down, and thus, balance your risk.
Adapting to Changing Market Realities
So what, if anything, has changed? As first became apparent during the Great Recession of 2008, globalization has made markets more susceptible to external shocks, causing increased volatility and stronger correlations between asset classes. This surprised investors who had expected different asset classes they held to zig while others zagged and instead experienced that as asset classes zigged, the others zigged, too—or zagged by a much smaller amount.
This doesnt mean, however, that diversification and asset allocation didnt work; they just didnt provide the level of protection that one would have hoped for. If anything, this experience shows us that we need asset allocation and diversification more than ever. Market volatility only reinforces their importance.
The relatively new availability of low-cost “nontraditional” asset classes can help. Investments like real estate (real estate investment trusts, or REITs), commodities (energy, agriculture, precious metals), Treasury Inflation Protected Securities (TIPS) and international bonds have historically had low correlation to traditional asset classes—moving differently in different markets—so adding small amounts to your portfolio can increase your diversification, potentially lowering your investment risk over timeRead More – Source