Construct a properly diversified portfolio
September 16, 2004
Most if you have heard me say: “Don’t put all of your eggs in one basket.” For years, financial experts have urged investors to spread their money across different types of asset classes – such as stocks, bonds, and cash – in order to reduce risk and enhance long-term returns.
Yet, all too often investors ignore this advice, pouring the bulk of their funds into a relatively narrow handful of investments – or even into a single stock. Proper diversification is an important factor to achieving long-term financial success. In this article, I will explore some of the many factors that must be taken into account to construct a properly diversified portfolio.
Modern Portfolio Theory:
The concept of diversification finds its roots in Modern Portfolio Theory. This theory states that portfolios created using a mix of different asset classes and investment styles deliver higher returns with less risk than any one asset would by itself. I believe the goal of asset allocation is to identify the best possible combination of stocks or other assets, based on their expected returns and the expected fluctuation – or volatility – of those returns over time. With this knowledge in hand, investors can construct portfolios that reflect this optimal mix as closely as possible.
An asset classes’ success is decided by the correlation between the rate of return and the level of risk in the portfolio. Therefore, the portfolio’s performance is dependent on the strength of the correlation. Modern Portfolio Theory predicts that the higher the risk, the higher the return. The same would hold true if the opposite were to occur; however, even asset classes with lower returns and a higher risk may improve portfolio performance. The portfolio performance is based on the strength of the relationship between risk and return.
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Experienced investors expect diversified portfolios to fall above any specific asset class on a chart that plots risk and return. This is because combining assets in diversified portfolios historically has allowed investors to earn higher returns with less risk than they could by investing in any single asset class alone. The most properly diversified portfolios reflect the best trade-off between risk and return given the various possible combinations of assets.
Asset Allocation Process:
Developing an asset allocation strategy requires an examination, using statistical estimates, that includes a careful analysis of both past asset class performance and expected future trends. While asset allocation begins with an analysis of historic asset performance, it doesn’t end there. The capital markets are constantly evolving and due to global economic, political or other forces. What occurred yesterday might not happen tomorrow. With many different variables and strategies impacting diversification decisions, many investors may find it difficult to chart an appropriate course.
In order to make the best decision, it is important to consider the factors that impact your asset allocation strategy. Besides past performance, I have mentioned that the expected returns, volatility of an asset class and the correlation between the two influence the portfolio performance and should impact your decision on which assets to allocate.
For more information on investment diversification, contact me today for a copy of Smith Barney Consulting Group’s White Paper, Investment Diversification Using Asset Allocation. I can be reached at 689-8700 or William.a.Creekbaum@smithbarney.com.
William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada.