KINGSTON April 30, 2007:
Author: Michael Lee - V.P. Asset Management & Research
Investing is a delicate balancing act. High return investments carry substantial risks, and low risk investments are associated with low potential returns. Since most of us would like to see our investments grow, and since taking on risk is the price of achieving this growth, it is not possible to completely eliminate risk from our portfolios.
Risk is the potential of an investment to generate financial loss. Return is the usual measure of performance. As investments that offer higher potential for total return generally carry a higher potential for risk, informed investors don’t simply seek to maximize returns. They instead focus on risk-adjusted returns; that is, the potential returns that correspond to the level of risk with which they are comfortable.
This tradeoff between risk and return is different for each investor. Some people don’t mind the wild gyrations of the stock market, while others prefer the steady income from T-bills and other fixed income securities. Either way, what is important is understanding your risk profile and how it translates into a disciplined approach to investing.
The linchpin to disciplined investing is diversification. This is a strategy designed to reduce exposure to risk by building a portfolio from a variety of investments which are unlikely to all move in the same direction at the same time.
There are a number of ways to diversify a portfolio. The primary way is to start by allocating a target percentage of your total investment to stocks, bonds, and cash. For example, if you are a young investor with a distant investment horizon, you may decide to invest 80% of your assets in stocks and 10% each in bonds and cash. An investor with a shorter investment horizon would be more cautious. He/She might decide to allocate 30% to stocks, 30% to bonds, and 40% to cash.
You should also diversify within each major asset class. For example, your stock portfolio should consist of securities from different industries that have low levels of correlation. An example of this diversification would be between technology and financial stocks, or technology and retail stocks. You may also consider splitting stocks according to other criteria, such as whether they are large capitalization or small capitalization stocks. Your bond and other investments should be similarly diversified (bonds, for example, may be diversified according to the issuer: government vs. corporations).
Diversification, however, can be expensive for the small investor. Buying sufficient securities to diversify a stock portfolio incurs transaction costs such as brokerage fees and other commission. When this is the case, investors should consider buying unit trusts or mutual funds, either of which provides greater diversification at a lower cost than buying the individual securities.
Bear in mind, though, that many mutual funds (unit trusts) require you to make a high initial investment (such as US$1,000), though subsequent investments can be as low as US$25. Also, mutual funds/unit trusts often concentrate their portfolios in one investment category and as a result you may still need to allocate among a few funds to gain the full benefits of diversification.
For the investors with copious capital, the investment universe is almost unlimited. These investors can seek diversification among many different asset classes, including real estate, currencies, commodity plays, hedge funds, private equity, and international securities. Indeed, allocating your investment dollars among this wide variety of assets sometimes reduce your risk while improving your return relative to the standard equity/bond/cash portfolios.
Diversification is certainly a prudent investment strategy for everyone, and you’d be hard pressed to find an experienced investor who will not sing its praise. But diversification is not a magic bullet. Diversification neither ensures a profit nor protects against a loss. And diversification reduces both the downside and upside potential of a portfolio (though it does allow for more consistent performance under a wide range of economic conditions).
To help you make suitable investment decisions, it’s important that you work with a Financial Advisor who understands your ability to tolerate risk as well as the factors that affect your decisions. A financial plan is a great starting point. |