BERLIN – In order to be successful in reaching your long-term financial goals, it is best to implement a varied approach that considers both strategic asset allocation and diversification.
Before you can properly allocate and diversify your portfolio, you must understand what the basic principles encompass. Asset allocation aims to balance risk by dividing an investor’s assets among three major categories – stocks, bonds and cash.
Each type of asset has a different level of return and risk, so each will impact your portfolio differently. Asset allocation takes into account the different ways stocks, bonds and cash have performed historically and uses those characteristics to improve the chances of achieving a desired total return over the long term. Asset allocation allows you to distribute your investments among the different types of assets to varying degrees. A solid asset allocation strategy balances riskier investments with steadier investments, and balances short-term with long-term investments.
There are several benefits to the implementation of a sound asset allocation strategy:
1. Reduces volatility over time: Stocks, bonds and cash generally do not gain or lose value concurrently. Having all three in a portfolio can help reduce volatility over time.
2. Helps protect against losses: The core of an asset allocation strategy is based on risk versus return. While some investors believe asset allocation is an investor’s way of settling for mediocrity, most financial experts will argue that a set allocation is a good protection against major losses.
3. Works in bull and bear markets: Rather than “putting all of your eggs in one basket,” using an allocation strategy that is designed so different investments respond to the market at different times will help improve the chances that your portfolio will be able to weather an economic downturn.
4. Can help increase returns and decrease risks: By understanding the risk-return characteristics of various asset classes, allocating the right asset can help decrease risks and increase returns.
Strategically dividing assets between stocks, bonds and cash is only half the battle. You also have to properly diversify within asset classes. Within the equity portion of your portfolio, you have to decide the right balance of investments in small, medium or large companies. With bonds, you need to know which bonds you want to invest in and how much to invest in each. Whether you select investment-grade municipal securities for their safety and tax-advantaged income stream, or corporate bonds because they often offer a higher yield (in exchange for greater risk), proper diversification can help to eliminate dangerous concentrations in any one particular security, sector or style. This helps you to avoid an investment strategy where you rely on timing the market’s ups and downs – often a losing strategy.
Your financial advisor can help you develop the discipline and consistency needed to build and strengthen your financial portfolio.
(The writer is a Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-9084.)