Let’s take a look at your GPA. You’re studying hard for the five classes that you’re taking this semester. All of them are challenging and you hope to do well in each, but after grades are in and you’re home for break looking at your report card, you shudder to find a D at the top of the list. This sends shivers down your spine and you hesitate to read on. Low and behold, you got a B+, two A-'s, and an A. Your GPA is not completely damaged, resting at 3.14 for the semester. The positive grades in your other courses have helped to mitigate the damage done by that one D in calculus. This is exactly how portfolio diversification works.
Let’s say you’ve got an investment portfolio and you're curious about what you should buy. Hopefully, this article tells you a bit more about what to look at and what to be concerned with. This is important because most the returns from your portfolio are going to come from only a few specific days for each thing that you’re invested in. Therefore, it’s important to get into the market early and get in as often as you can. You may know about asset classes; they are the broad categories that the things that you purchase fit into. For example, AMD is the stock that you buy it is within the broader category of large capitalization stocks (since AMD is valued over $10 billion).All large capitalization stocks fall within the “equities” category. The categories I just described are asset classes and each asset class carries a different kind of risk.
From a student perspective, Economics 103 is the stock, “an economics course” is the asset class, and a “college course” is the broadest asset class. Harder courses can be viewed as riskier because you may not do well in them and that can hurt your GPA. Risky companies can be thought of in the same way. Taking some easy courses can help to mitigate the risk of a GPA in each semester of college. Buying many companies with different levels of risk can help to mitigate the chance that your portfolio will do poorly over a given period. Going back a little to the investment side of things, it’s important that you rotate your asset classes periodically to make sure that you aren’t putting more of your eggs in one basket than you should.
Portfolios are delicate things and there are many ways of picking what to buy with them. Cash isn’t typically viewed as an investment (even though inflation and interest rates make it one). You should probably have your entire portfolio invested in something (if you have enough money set aside for emergencies). There is no typical portfolio and each portfolio should be different depending on the amount of risk that you are willing to take on. Over a long period of time, all assets rise in value. It’s just making sure that you stay invested long enough to realize that gain. You could go out and buy a bunch of penny stocks, and some may take off and some may not. This is risky not because you’re investing in penny stocks, but because you aren’t investing in large companies like Apple as well. But even if you’ve invested in Apple, Coca-Cola, and a bunch of penny stocks, you’ve still opened yourself up to a lot of risks because you’ve put all your eggs into the “stocks” basket.
A fully diversified portfolio likely contains a little bit of everything from bonds, stocks, preferred stocks, REITs, commodities, and maybe even currencies. Within each of these asset classes, you can drill down further. For instance, you could own corporate bonds, government bonds, junk bonds, etc. These are good components of a bond portfolio. The best way to go about this is to start with the size of your portfolio and say, “I’m going to invest $10,000” and then decide how much of that $10,000 should be invested in bonds, stocks, real estate, etc. Let’s say you want to put at least half of your $10,000 in stocks. This means that you have $5,000 to invest in the stock market, but you should break it down further into different asset classes. You have $5,000 to spread between large companies, small companies, growth companies, and value companies, just to name a few. That’s usually the best way to start figuring out what to buy. Once you have decided how to cut your portfolio pie, then you have a lot of research to do to pick what exactly you’re going to buy.
Next time I’ll get into some risk measures that everyone should be aware of and how to consider risk when building your portfolio. I’m going to leave you with this fact when thinking about asset classes: A widely-cited study of pension plan managers found that 91.5% of the difference between a portfolio performance and the benchmark or another portfolio is explained entirely by asset allocation. Asset allocation can determine if you’re Warren Buffet or a major bank holding the bag on bad mortgage loans, so do your research and rebalance.
Sources
Bergen, Jason Van. 2017. 6 Asset Allocation Strategies that Work. http://www.investopedia.com/articles/04/031704.asp.
CNN Money. 2017. Accessed April 22, 2017. http://money.cnn.com/retirement/guide/investing_basics.moneymag/index7.htm.
Tuchman, Mitch. 2015. Investing Basics: What Is Asset Allocation? March 20. Accessed April 22, 2017. https://www.forbes.com/sites/mitchelltuchman/2015/03/20/investing-basics-what-is-asset-allocation/#54ef6a7170d1.