If you have funds in an investment portfolio, you are probably familiar with the term diversification. Also called asset allocation, diversification refers to how you invest your money, whether in stocks or fixed income investments. Diversification works because you invest your money in a variety of styles, such as stocks and bonds, and by doing so you aim to reduce your investment risk.
The main reason diversification works is twofold. One reason is that it is very unlikely for all types of investments to lose money at once. The second reason is that diversification takes a long-term view to investing. While many people have tried, it is very difficult to predict the market’s short-term performance. For instance, in 1992, foreign stocks had the worst return of any market sector while in 1993 it had the best return.
Since one year stocks might do well but the next year bonds are king, diversification works because, over the years, there are more winners than there are losers. With some money in equities and some money in fixed income investments, over the long term you can expect to come out ahead.
The percentage of your portfolio to put into each segment will depend upon several things including your income, your age and time to retirement, your life expectancy and your risk tolerance. Investors with a low risk tolerance tend to put more of their portfolio into fixed income investments. However, because the rate of return on these investments might be so low that they cannot even keep up with inflation, it is important for even the least risk tolerant investor to have some of their portfolio invested in equities.
By investing in higher risk vehicles, the investor has the potential of higher investment returns, in general, the higher the return of the investment the higher the risk. While this type of investing is not meant for everyone, every investor should consider having at least part of their portfolio in a higher return investment to protect their money from being eaten away by inflation. The amount to invest, of course, will be dependent upon how well the investor can sleep at night, knowing some of their money is at risk.
For short-term goals, such as a college education, fixed income investments could make the best investment. This is money that would be hard to replace in a short time frame if it was lost. In addition, there is the time deadline, meaning that if the investment goes down, there is less time available to recoup the loss. For this type of situation, savings accounts, bonds and certificates of deposits would be appropriate.
When investing, keep in mind that while stocks have the most risk, they also have, over time, the highest rate of return. Bonds, which are fixed income investments, have less volatility than stocks if the bond is held to term. The return is modest but it can be regular and steady. In addition, while bonds are considered a fixed income investment, some bonds can be very risky, such as high yield or junk bonds. Bond ratings should be carefully considered before investment.
As a fixed income investment, cash accounts such as treasury bills, money market accounts and CDs are the safest. However, over time, they do offer the lowest rate of return and, as mentioned previously, might not even be able to protect your savings against inflation.
When you are ready to invest money, learn as much as you can about the different types of equity and fixed income investments. It is important to understand the relationships between risk and return, diversification and asset allocation and the right time to re-balance your portfolio. For a resource to learn more about these topics, the Securities and Exchange Commission has an excellent article titled ‘Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing” that is available for free.