A Case for Diversity

Polarizing the potential options to chose from, Jaime Zimmerman weighs in on the value and risk in asset management.

Polarizing the potential options to chose from, Jaime Zimmerman weighs in on the value and risk in asset management.

Most of us are familiar with the expression, “Don’t put all your eggs in one basket.” Yet individuals who invested heavily in technology stocks in the late 1990s did just that, and many investors lost substantial portions of their assets when the stock market bubble burst and concentrated positions in highly valued stocks declined significantly. Even today, those who hold high concentrations of financial stocks have suffered more severe losses in an already extreme environment.

On the other end of the spectrum, risk-averse investors who place all their money in conservative investments, such as bonds and cash, miss out on the long-term growth potential of stocks that can help protect their portfolios against inflation. Generally, the more conservative the investment, the lower the return you should expect.

Asset allocation is an important tool and refers to the percentage of money you should consider for various asset classes such as stocks, bonds or cash. The asset allocation process determines approximately 90% of investment performance and is the crucial factor for portfolio success, according to a widely recognized academic study.

Allocating your assets begins by deter-mining your time horizon and tolerance for risk. Time horizon refers to your age and the number of years you have to invest before you need the money. Having more time allows you to bear greater risk because you’ll be able to ride out the fluctuations of market cycles.

Everyone has a different comfort level regarding risk. If you see the market drop by 20% and view it as an opportunity, you have a high tolerance for risk. If the idea of losing 20% keeps you up at night, your risk tolerance is low. The lower your tolerance, the more you should consider bonds and cash. But you’ll also need to lower your expectations for returns.

Based upon these parameters, portfolios are structured using stocks, bonds and cash. Each of these asset classes can be diversified further to include different types of investments including the combination of growth and value stocks; small-, mid- and large-capitalization stocks; international equities; and government, municipal and corporate bonds. Large portfolios with longer time horizons and higher risk-tolerances may consider alternative investments such as high yield bonds, real estate or private equity. Finally, the investor and financial advisor should together determine the appropriate portfolio implementation.

Although most professionals agree that diversification is desirable, portfolio efficiency is predicated upon effective diversification. Improving investment results depends upon building diversified and efficient portfolios. How the assets relate or correlate to each other is even more important than just adding more securities or assets. Through a careful analysis, your financial advisor can help recommend an appropriate mix of asset classes designed for your objectives.