Keeping your portfolio loaded with majority stocks that are too risky could mean heavy losses if prices crash; on the other hand keeping investments that are too low risk and low return could hit profit margins.
What is a diversified portfolio?
Normally you would see the following mix of investments recommended by a Fund Manager:
- Stocks and mutual funds that are high on the scale of risk but which also harbor potential for the highest growth. These are great for long term financial goals like retirement.
- Bonds, both government treasury and company bonds that are more stable but exhibit lower potential growth rates, ideal for financing medium term goals like buying a car, or financing children’s education.
- Certificates of deposit (CDs) and money market funds are grouped in the lower end of the spectrum because they pose the least risk but have just nominal growth. These are OK for fulfilling short term goals that cannot be held captive to high risk volatile stocks.
Why are investments diversified?
The fundamental reason for retaining assets with different risk profiles is to minimize losses in your portfolio and maximize the earnings. If the portfolio is overloaded with high risk stocks a single loss could wipe out your invest base. To hedge that risk we balance the portfolio with medium and low risk assets that will act as a safety net and continue to generate income in the face of any high profile loss. As we have already seen stocks can be mixed and matched to suit different tenures and long term financial goals.
Another major advantage of a diversified investment portfolio is the enhanced stability that it promotes. It is generally observed that when stocks fall the demand for bonds increase, as bonds act as a kind of bulwark protecting your assets against price fluctuations in a volatile market. Similarly when US stock markets decline, overseas markets show gains. By diversifying our asset base we offset possible losses in one area through solid gains in another area.
Bringing more complexity to asset diversification
The individual investor might be satisfied with a simple mix of assets like stocks, bonds, mutual funds and CDs but the avid investor might decide to further protect his investment base by diversifying within each asset class. In such a diversified portfolio one would see a mix of safer US treasury bonds and riskier but high earning corporate bonds, safer mutual funds and high earning index funds (as opposed to individual company stocks), and penny stocks (lower in value but larger in volume) rubbing shoulders with blue chip stocks.
Ultimately, any investment boils down to risk
Financial consultants, fund managers, stock brokers and bankers may suggest a variety of investments but the predominant factor will be the risk profile of the constituent assets and to what extent you would be willing to absorb risk. You will have to personally satisfy yourself that your fund manager is properly implementing your investments in tune with your avowed financial goals, and not mismanaging your money.
It helps a great deal to have a backup plan to tackle losses
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