Most of us know the expression, “Don’t put all your eggs in one basket.” Yet those who invested heavily in technology stocks in the late 1990s did just that, and many lost substantial assets when the bubble burst and concentrated positions in these overvalued stocks declined significantly. On the other hand, risk averse investors who place all their money in conservative investments like bonds and cash miss the long-term growth potential of stocks that can help protect portfolios against inflation. The asset allocation process, or investment diversification across asset classes, determines approximately 90% of investment performance and is the crucial factor for portfolio success, according to a widely recognized study by Brinson, Singer and Beebower.
The asset allocation process begins by determining the investor’s time horizon, investment goals, current assets and tolerance for risk. Based on these parameters, target portfolio percentages are assigned to stocks, bonds and cash. Next, asset class allocations are made within each category based upon their correlation (i.e., the relationship between asset classes) and expected risk and return characteristics. Each of these asset classes can be diversified to include different types of investments, including the combination of growth and value stocks; small-, mid- and large-cap stocks; international equity; and government, municipal and corporate bonds. Finally, the investor and financial adviser should determine the appropriate portfolio implementation.
While diversification cannot ensure against loss or guarantee a profit, most professionals agree it can be desirable. But portfolio efficiency is predicated upon effective diversification. Greater diversification through the mere addition of securities or asset classes does not always improve portfolio results and can actually hinder the portfolio. The greatest potential for improving investment results largely depends on building diversified, efficient portfolios. Through careful analysis, your adviser can help recommend an appropriate mix of asset classes designed for your objectives.