- It is one way to balance risk and reward in your investment portfolio by diversifying your assets.
- Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited. This practice is designed to help reduce the volatility of your portfolio over time.
- One of the keys to successful investing is learning how to balance your comfort level with risk against your time horizon.
Invest your retirement nest egg too conservatively at a young age, and you run a twofold risk:
(1) The growth rate of your investments won't keep pace with inflation
(2) Your investments may not grow to an amount you need to retire with.
- Conversely, if you invest too aggressively when you're older, you could leave your savings exposed to market volatility, which could erode the value of your assets at an age when you have fewer opportunities to recoup your losses.
- One way to balance risk and reward in your investment portfolio is to diversify your assets. This strategy has many different ways of combining assets, but at its root is the simple idea of spreading your portfolio across several asset classes. Diversification can help mitigate the risk and volatility in your portfolio, potentially reducing the number and severity of stomach-churning ups and downs. Remember, diversification does not ensure a profit or guarantee against loss.
Factoring time into your diversification strategy
- People are accustomed to thinking about their savings in terms of goals, retirement, college, a deposit for a new home, or a vacation. But as you build and manage your asset allocation regardless of which goal you're pursuing, there are 2 important things to consider.
- The first is the number of years until you expect to need the money also known as your time horizon.
- The second is your risk tolerance. For instance, think about a goal that's 25 years away, like retirement. Because your time horizon is fairly long, you may be willing to take on additional risk in pursuit of long-term growth, under the assumption that you'll usually have time to regain lost ground in the event of a short-term market decline. In that case, a higher exposure to domestic and international stocks may be appropriate.
- But here's where your risk tolerance becomes a factor. Regardless of your time horizon, you should only take on a level of risk with which you're comfortable. So even if you're saving for a long-term goal, if you're more risk-averse you may want to consider a more balanced portfolio with some fixed income investments. And regardless of your time horizon and risk tolerance, even if you're pursuing the most aggressive asset allocation models, you may want to consider including a fixed income component to help reduce the overall volatility of your portfolio.
- The other thing to remember about your time horizon is that it's constantly changing. So, let's say your retirement is now 10 years away instead of 25 years you may want to reallocate your assets to help reduce your exposure to higher-risk investments in favour of more conservative ones, like bond or money market funds.
- This can help mitigate the impact of extreme market swings on your portfolio, which is important when you expect to need the money relatively soon.
- Regardless of your goal, your time horizon, or your risk tolerance, a diversified portfolio is the foundation of any smart investment strategy.
