What's the best way to invest your hard-earned capital? It's investors' age-old question — and why so many turn to trusted wealth advisors for help.
Because while the process of building an investment portfolio may seem, in itself, simple, creating an effective portfolio involves realistic goal setting, a long-term time horizon that stretches across a few decades, a modicum of self-discipline and, significantly, risk awareness. Combined, these factors create the recipe for a diversified portfolio that's tailored to meet your specific financial needs.
The key, as your portfolio manager will tell you, lies in creating a truly diversified portfolio.
Financial Planning Tools: Goals, Time Horizons and Risk Awareness
For some investors, a diversified portfolio simply means a portfolio that contains a number of different investments, but this isn't the key to true diversification. Granted, an important element of the portfolio planning process does involve choosing investments to meet specific goals; for instance, saving for a down payment on a house vs. retirement savings accounts. But diversification depends on how risk is spread across investments, rather than the number of investments — and the key lies in diversifying risk.
In theory, the risk continuum states that conservative, less aggressive investments create the potential for lower returns, while investments at the opposite end of the spectrum have the potential to produce higher returns. Following are a number of different investment asset classes, that, based on historical analysis, have been ranked from least to most risky:
- FDIC-insured certificates of deposit (CDs)
- Money market and savings accounts
- U.S. Treasury bills
- Government bonds
- Corporate bonds
- Large cap stocks
- Mid cap stocks
- Small cap stocks
- International stock markets
- Real estate
- Emerging markets
Why is risk allocation so important? Because in a properly diversified portfolio, you'll be invested across a number of different asset classes. That means that even if one loses value, you've still got many other buckets in your portfolio, thus spreading the risk.
Asset Management Solutions: Achieving True Diversification
How is an investor to decide how to spread risk across multiple asset classes? The amount you allocate should be based largely on your level of risk tolerance, which is, in turn, based on factors including:
- Your time horizon
- Your level of comfort with market fluctuations
- Your liquidity needs
For instance, investors age 40 and under have a longer time horizon; their portfolios may be more heavily weighted toward stock investments. In contrast, investors who are closer to retirement — i.e. investors aged 50 and up — may want to shift some focus on fixed-income securities, such as bonds. Essentially, such investments allow you to trade higher returns for more stability. Investors who are in retirement already may want to consider a portfolio that's more heavily weighted toward lower-risk investments. Either way, it's essential keep a long-term focus, rather than reacting to every up and down.
As for when to buy assets, ignore the sensationalism coming out of the financial media. Because you have a long-term perspective, you can focus on factors like interest rates and price-to-earnings ratios when making investment decisions, rather than day-to-day market fluctuations.
But once you get that portfolio diversified, don't just "set it and forget it." Meet regularly with your wealth advisor to rebalance your portfolio. If certain asset classes have grown or receded beyond the original parameters you set up with your portfolio manager, you may need to reallocate investments to regain that balance.