The importance of diversification to offset risk

 James Quackenbush, The Daily Record Newswire

Asset allocation is the strategy of distributing risk between different investment classes such as stocks, bonds, and cash. By having your portfolio invested in different asset categories, you can protect your portfolio from losing substantial value when one asset class declines precipitously. When a portfolio includes investments in a variety of assets classes, large losses in one asset class could be offset by gains in others.

Lately, the stock market has been making all-time highs and investors are forgetting the importance of their bond allocation inside their portfolio. When making asset allocation decisions, an investor should always ask themselves: “Can I afford not to be invested in bonds?”

When the stock market lost substantial value in 2008 and 2009, U.S. Treasury prices rallied as investors moved their money into a less risky asset class. A portfolio that included stocks and bonds performed better than one invested in only stocks during the market crash. However, when stock markets have a strong year, as they did last year, a balanced portfolio will underperform the stock market. The bottom line is that investors should never forget the importance of their bond allocation because over a full market cycle, a balanced portfolio will produce superior risk-adjusted returns.

Having the proper asset allocation is therefore essential to achieving one’s investment goals. The allocation ratio should reflect an individual’s risk tolerance and, perhaps more importantly, their age. A rule of thumb is to invest your age in bonds. An investor that is 40 years of age should have a portfolio of roughly 60 percent stocks and other alternative investments and 40 percent in bonds, give or take 10 percent depending on market conditions. Furthermore, as an investor gets closer to retirement, they should slowly be reducing their stock market exposure and moving more money to less volatile investments.

Once an appropriate mix of stocks, bonds, and other investment vehicles has been determined, the equity portion of the portfolio should be diversified to reduce stock market risk. This can be achieved by using a combination of different funds with investment objectives in large-cap, mid-cap, small-cap, growth and value stocks. An investment portfolio should not contain only companies with large market capitalizations. Having a portfolio diversified with a variety of companies with different market capitalizations will help produce a balanced portfolio that reduces stock market risk.

Additionally, diversifying with a mix of growth and value-oriented companies will further reduce overall portfolio risk. Growth stocks consist of companies that tend to have earnings that grow faster than their industry or the overall markets, and are unlikely to pay a dividend. Growth stocks tend to outpace the overall market when the economy is healthy and expanding.

Alternatively, value stocks consist of companies that are considered to be undervalued but have strong fundamentals and often pay dividends to their shareholders. Value stocks tend to underperform when the economy is growing. However, they tend to limit downside risk in a portfolio when the economy is contracting and offset losses from more aggressive segments of a portfolio. Having a good balance of both growth and value stocks will reduce risk and prove beneficial through a full market cycle.

Diversification is critical for minimizing risk in one’s portfolio. Using an asset allocation strategy containing both stocks and bonds, along with a variety of funds with different investment objectives, will help produce a portfolio that is diversified and has limited risk in the event one aspect of the portfolio loses significant value.

Although the stock market has produced substantial returns as of late, one should not forget the pain felt from the stock market sell-off of 2008 and 2009. Therefore, a well-balanced investment portfolio will prove beneficial for the long-term investor. Before making any investment decisions regarding your portfolio, please consult with your investment professional.

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James Quackenbush is a senior domestic equity analyst for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. He can be reached at (585) 586-4680.

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