Risk Management: Understanding Diversification
When you created your investment strategy, your asset allocation reflected your goals, time horizon and tolerance for risk.
Over time, however, any of these three factors may have changed, and your portfolio may need adjustments to reflect your new investing priorities.
Diversification
The saying “don’t put all your eggs in one basket” has some application to investing. Over time, certain asset classes may perform better than others. If your assets are mostly held in one kind of investment, you could find yourself under a bit of pressure if that asset class experiences volatility.
Keep in mind, however, that diversification is an approach to help manage investment risk. It does not eliminate the risk of loss if an investment sees a decline in price.
Asset allocation strategies are also used in portfolio management. When financial professionals ask you questions about your goals, time horizon, and tolerance for risk, they are getting a better idea of what asset classes may be appropriate for your situation. However, like diversification, asset allocation is an approach to help manage investment risk. It does not eliminate the risk of loss if an investment sees a decline in price.
Determining an Appropriate Mix
Appropriate asset allocation is determined by each individual's situation. Here are three broad factors to consider:
Time
Investors with longer timeframes may be comfortable with investments that offer higher potential returns but also carry a higher risk. A longer timeframe may allow individuals to ride out the market’s ups and downs. An investor with a shorter timeframe may need to consider market volatility when evaluating various investment choices.
Goals
They come in all shapes and sizes, and some are long-term, while others have a shorter time horizon. Knowing your investing goals can help you keep on target.
Risk Tolerance
An investor with higher risk tolerance may be more willing to accept greater market volatility in the pursuit of potential returns. An investor with a lower risk tolerance may be willing to forgo some potential return in favor of investments that attempt to limit price swings.
Have Your Investing Priorities Changed?
If so, this is all the more reason to review and possibly adjust the investment mix in your portfolio. Asset allocation is a critical building block of investment portfolio creation. Having a strong knowledge of the concept may help you when considering which investments are appropriate for your long-term strategy.
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