Risk Management: Diversification and Strategic Portfolio Asset Allocation

Diversification is a strategy that reduces risks specific to company and industry (e.g., business and financial risks). It’s important to remember that no matter how diversified your portfolio is, risk cannot be eliminated completely. A well-balanced portfolio reflects the ever-changing market need for risks and returns related to those risks.

Although, it does not guarantee against loss, diversification is the most important component of reaching long-term financial goals while minimizing risks. The key goal of diversification is to set the appropriate level of risk for an investor’s time horizon, financial goals, and tolerance for portfolio volatility.

There are two very important aspects of building a well-diversified portfolio: investments correlation and diversification within each type of investment.

Correlation is a measure of how the values of two investments move together (whether their values move in the same or in opposite directions). To build a balanced and well-diversified portfolio, an investor should look for assets whose returns historically moved in opposite direction. This simply means that two different investments respond differently to the same events. The less correlated the assets are in your portfolio, the more efficient the trade-off between risk and return.

To achieve diversification within each type of investment- you may not want one stock to make up more than 5% of your stock portfolio and you may want to diversify across stocks by capitalization (small, mid-, and large caps), sectors, and geography. Again, not all caps, sectors, and regions prosper at the same time, so you may be able to reduce portfolio risk by spreading your assets out. If you are investing in funds, you may want to consider a mix of funds, such as equity, income, equity-income and money market funds. To increase your bond allocation –you may want to consider bonds with varying maturities, styles, and sensitivity to inflation and interest rate changes.

Portfolio rebalancing is extremely important because it helps you maintain your portfolio target asset allocation. Inevitable and constant changes in the market cause an imbalance in your portfolio that may overweight or underweight one or more asset classes. Restoring the original asset mix will keep your plan on track to help accomplish your long-term goals. This is why meeting with your financial advisor and reviewing your portfolio regularly is necessary.

Please feel free to contact me to help you determine if you have a well-designed asset allocation plan in place or to help you create and implement a well-balanced portfolio.