By: Matthew Kovach, Investment Analyst
Whenever you are listening to a conversation or reading the news, it is not uncommon to come across a number of buzz-words and phrases and wonder, “What does that mean?” Here are two of those phrases: asset allocation and diversification.
Portfolio construction around your investments is about finding a balance between short-term stability and long-term growth by allocating your investments across various asset classes (stocks, bonds, and cash). This is known as asset allocation and it is a primary driver of your portfolio’s performance over time. Understanding how to strike a balance between your time horizon and your degree of comfort with risk is one of the keys to successful investment. If you invest your retirement savings too cautiously with a long time horizon, you risk that your assets won't increase at a rate that keeps up with inflation and they won't grow to the level that would allow you to fulfill your retirement objectives. At the other end, if you invest aggressively as your time horizon shortens, you run the risk of leaving your funds vulnerable to market fluctuations, which might depreciate your assets at a time when you have fewer possibilities to make up for your losses. Thus, it is important to understand the different asset classes.
Stocks represent an equity ownership stake in a company. Stocks provide the most opportunity for growth and capital appreciation within your portfolio over the long term but also represent the most aggressive portion of your investment. Over a short time horizon, stocks are a more volatile asset class and carry greater amounts of risk. Stocks can be grouped by the “style box”, which is a graphical representation is relating to the company’s size and propensity for growth.
Bonds are investment vehicles that provide regular interest income and a repayment of principal at maturity (assuming no default) and are viewed as less volatile than stocks. In contrast to owning a stock, owning a bond is ownership of debt in a company. Because bonds and stocks have little correlation amongst each other, bonds can mitigate unpredictable swings in the stock market. Risk-adverse investors, or those looking to diversify a portfolio, often favor bonds and are willing to accept lower returns in favor of lower risk. However, note that fixed income investments such as bonds offer various combinations of risk and return depending on the credit quality of the underlying bond. For example, investment grade bonds offer lower returns than high yield bonds but also offer lower risk.
Short-term investments include money market funds and short-term CDs (certificates of deposit). Money market funds are conservative investments that provide stability and convenient money access, making them the best choice for investors who want to protect their principal. Money market funds often offer lower returns than bond funds or individual bonds in exchange for that level of safety. Money market funds (not to be confused with money market accounts) are not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC), unlike many CDs, despite the fact that they are thought to be safer and more conservative. However, you run the risk of giving up the liquidity that money market funds often provide when you invest in CDs.
Diversification, which is the practice of spreading your investments within each asset class so that your exposure to any one asset is limited, is another driver of portfolio performance and is designed to reduce portfolio volatility over time. The chart below demonstrates how diversifying your portfolio over asset classes may provide better returns with less risk over time as the performance of each asset class rotates every year.
Taken together, asset allocation and diversification are key components of the portfolio construction process and finding the right asset mix that is appropriate for your risk tolerance and investment horizon is crucial to meeting your portfolio objectives.