You have heard over and over how important diversification and asset allocation is for a successful investment strategy. Have you wondered why they are important and what role they play in your portfolio? I will attempt to define these terms and explain how bonds are still integral to controlling risk despite our low interest rate environment.
The stocks in your investment account are typically a higher risk, higher potential reward asset. But not everyone can stomach the ups and downs and each person should consider their tolerance. The purpose of risk tolerance is to make sure you don’t pull the trigger and sell an investment just because its value has dropped. Stocks go up and down and buy/sell decisions should be based on fundamentals, not price swings. Diversification and Asset Allocation are two levers we can pull to help mitigate the risks a portfolio is exposed to.
The way we use Tolerance is to gauge your capacity to take risk and your willingness to take risk. These two dimensions and our conversation with our client determine a level of appropriate risk in the context of a financial plan.
The purpose of diversification and asset allocation is to control the risk so you can tolerate the ups and downs. Diversification means owning more than one type of investment in your portfolio. You can own your favorite stock, but you may want to own others of different sizes or from different industries, so your risk exposure is varied. And you do not want to own too much of any one stock. For example, if all your money is in XYZ Bank and they go bankrupt, you could potentially lose everything. This is called concentration risk. You should have several holdings in your portfolio to protect against a 100% loss, otherwise you are just gambling. Investing involves risk, but good diversification helps protect you from a permanent loss because while one stock may be a loser, several others could be winners. That is what a Fund typically does. You buy one fund and you get a lot of holdings and reduce concentration risk. Many of you may remember the company Enron. This was a popular stock to own several years ago and many of the employees had their entire retirement savings in that stock. But turns out they were a multi-billion dollar fraud and many employees and retirees lost everything. Their jobs and their retirement. Diversification may help with protecting against a permanent loss, but it might not be enough to help you tolerate volatility. This is where Asset Allocation can help.
Stay tuned for my next blog post on Asset Allocation.