Diversification Creates Robust Risk Adjusted Returns
Asset diversification plays a key role in any investor’s portfolio. Many investors may be thinking why asset diversification is important and properly maintained. The ultimate goal of asset diversification is to strengthen your portfolio and consistently boost performance. When diversifying your portfolio there is no guarantee against loses, however, once you decide on your risk level based on your overall goals asset diversification will potentially help the investor to improve their returns.
A strong diversified portfolio will consist of assets which will incorporate stocks, cash, bonds as well as other assets which don’t move in the same direction. The term diversification means just as it sounds that your assets are well diversified and that if a portion of your portfolio is decreasing in value other portions of your portfolio will be increasing in value because the portfolio is well diversified. The objective of diversification is to offset the impact of poor performance in some of your assets while the rest of your portfolio is growing.
When reviewing your overall portfolio, an investor should not be to heavily weighted in one particular security. The rule of thumb is that you should not have more than five percent of your portfolio in one particular stock holding. If you are over concentrated in one particular class this could invariably spell disaster. If a stock holding makes up a large percentage of your assets and this particular security tanks the rest of your portfolio could invariably tank as well.
Again, when mixing your portfolio of securities there is zero guarantee that these combinations of different asset classes will work at the same time. However, the investor does increase the odds of gains when mixing a well diversified portfolio of assets spread across different parts of the stock market. This rational also goes for your mix in the bond markets. The portfolio investor should take into consideration bonds with varying maturities, durations, credit qualities which typically measure responsiveness to elements such as interest rate changes.
It is important to have a defined amount of risk level that the portfolio investor can live with. Usually, the value of a diversified portfolio plays out over time. May investors don’t realize the benefits of their investment strategy because when markets are rising during good times investors have a tendency to run after performance and buy higher risk assets. During a downturn, investors usually flock to lower risk investment options which may lead to missed opportunities particularly during market recoveries.
Building a well diversified portfolio is not an easy task. The investor should be certain he/she understands their objectives to capital growth and that they are using the right mix of asset classes. The investors mix should incorporate stocks, bonds and short term investments which are aligned to the investor’s time frame, needs along with comfort level.
In closing, asset diversification is paramount when creating a portfolio. An investor should not assume that their asset class mix is going to work but that they have a well thought out strategy when it comes to diversification. An investor does not want to put all their eggs in one basket to see their hard earned money go down the tubes.