Like every investor, you want to choose investments that will provide the growth and income you need to meet your financial goals. To do that, it’s important to understand yourself as an investor. That’s because a portfolio that’s right for someone else may not be best for you. The factors that make a difference are stated below.
Your risk tolerance
Both your age and your time frame for meeting specific financial goals play a role in determining your risk tolerance. If you’re young and have a long time to meet your goals, you may have a higher risk tolerance than someone who is nearing retirement and is counting on investment income to live on for two or three decades.
But other factors may also affect your tolerance for investment risk. Your personality, personal experiences, and current financial circumstances also come into play. For instance, if you’re a single parent, are responsible for the care of a sick or elderly relative, or have lived through a period of economic upheaval such as a major recession, you may be a more risk-averse, or conservative, investor. On the other hand, if you have a promising career, a generous salary, and little in the way of financial responsibilities, then you may be more comfortable in assuming greater investment risk.
Above all, you need to feel comfortable with the risk you’re taking. If changes in the value of your portfolio keep you tossing and turning at night, or your instinct is to sell your investments every time the market drops, then you may want to consider shifting to a more moderate investment mix, with a greater emphasis on predictable, income-producing investments, such as bonds.
Or, if you’re a risk taker by nature and have at least 15 years to meet your goals, then you may be comfortable allocating most of your assets to a diversified portfolio of stock, stock funds and certain fixed-income investments that have the potential to provide the strongest returns over the long run.
Keep in mind that investment risk doesn’t mean staking your life savings on highly speculative investments like a new company that a friend is starting. (The only money you’d want to put in investments like that is money you can afford to lose.) But it does mean getting used to the fact that virtually all investments that have the potential to provide substantial returns will drop in value at one time or another—sometimes significantly.
Using asset allocation
When you allocate your assets, you decide—usually on a percentage basis—what portion of your total portfolio to invest in different asset classes, usually stock, bonds, and cash or cash equivalents. You can make these investments either directly by purchasing individual securities or indirectly by choosing funds that invest in those securities.
As you build a more extensive portfolio, you may also include other asset classes, such as real estate, which can also help to spread out your investment risk and so moderate it.
Asset allocation is a useful tool in managing systematic risk because different categories of investments respond to changing economic and political conditions in different ways. By including different asset classes in your portfolio, you increase the probability that some of your investments will provide satisfactory returns even if others are flat or losing value. Put another way, you’re reducing the risk of major losses that can result from over-emphasizing a single asset class, however resilient you might expect that class to be.
For example, in periods of strong corporate earnings and relative stability, many investors choose to own stock or unit trusts. The effect of this demand is to drive stock prices up, increasing their total return, which is the sum of the dividends they pay plus any change in value. If investors find the money to invest in stock by selling some of their bond holdings or by simply not putting any new money into bonds, then bond prices will tend to fall because there is a greater supply of bonds than of investors competing for them. Falling prices reduce the bonds’ total return. In contrast, in periods of rising interest rates and economic uncertainty, many investors prefer to own bonds or keep a substantial percentage of their portfolio in cash. That can depress the total return that stock provides while increasing the return from bonds.
While you can recognize historical patterns that seem to indicate a strong period for a particular asset class or classes, the length and intensity of these cyclical patterns are not predictable. That’s why it’s important to have money in multiple asset classes at all times. You can always adjust your portfolio allocation if economic signs seem to favor one asset class over another.
Financial services companies make adjustments to the asset mix they recommend for portfolios on a regular basis, based on their assessment of the current market environment. For example, a firm might suggest that you increase your cash allocation by a certain percentage and reduce your equity holdings by a similar percentage in a period of rising interest rates and increasing international tension. Companies frequently display their recommended portfolio mix as a pie chart, showing the percentage allocated to each asset class.
Modifying your asset allocation modestly from time-to-time is not the same thing as market timing, which typically involves making frequent shifts in your portfolio holdings in anticipation of which way the markets will turn. Because no one knows what will happen, this technique rarely produces positive long-term results
When you diversify, you divide the money you’ve allocated to a particular asset class, such as stocks, among various categories of investments that belong to that asset class. These smaller groups are called subclasses. For example, within the stock category you might choose subclasses based on different market capitalizations: some large companies or funds that invest in large companies, some mid-sized companies or funds that invest in them, and some small companies or funds that invest in them. You might also include securities issued by companies that represent different sectors of the economy, such as technology companies, manufacturing companies, pharmaceutical companies, and utility companies.
Similarly, if you’re buying bonds, you might choose bonds from different issuers—the government and corporations—as well as those with different terms and different credit ratings.
Diversification, with its emphasis on variety, allows you to manage nonsystematic risk by tapping into the potential strength of different subclasses, which, like the larger asset classes, tend to do better in some periods than in others. For example, there are times when the performance of small company stock outpaces the performance of larger, more stable companies. And there are times when small company stock falters.
Similarly, there are periods when intermediate-term bonds provide a stronger return than short- or long-term bonds from the same issuer. Rather than trying to determine which bonds to buy at which time, there are different strategies you can use.
For example, you can buy bonds with different terms, or maturity dates. This approach, called a barbell strategy, involves investing roughly equivalent amounts in short-term and long-term bonds, weighting your portfolio at either end. That way, you can limit risk by having at least a portion of your total bond portfolio in whichever of those two subclasses is providing the stronger return.
Alternatively, you can buy bonds with the same term but different maturity dates. Using this strategy, called laddering, you invest roughly equivalent amounts in a series of fixed-income securities that mature in a rolling pattern, perhaps every two years. Instead of investing Rs15,000 in one note that will mature in 10 years, you invest Rs 3,000 in a note maturing in two years, another Rs 3,000 in a note maturing in four years, and so on. This approach helps you manage risk in two ways:
If rates drop just before the first note matures, you’ll have to invest only Rs3,000 at the new lower rate rather than the full Rs 15,000. If rates behave in traditional fashion, they will typically go up again at some point in the ten-year span covered by your ladder.
If you need money in the short term for either a planned or unplanned expense, you could use the amount of the maturing bond to meet that need without having to sell a larger bond in the secondary market.
How much diversification?
In contrast to a limited number of asset classes, the universe of individual investments is huge. Which raises the question: How many different investments should you own to diversify your portfolio broadly enough to manage investment risk? Unfortunately, there is no simple or single answer that is right for everyone. Whether your stock portfolio includes six securities, 20 securities, or more is a decision you have to make in consultation with your investment professional or based on your own research and judgment.
In general, however, the decision will depend on how closely the investments track one another’s returns—a concept called correlation. For example, if Stock A always goes up and down the same amount as Stock B, they are said to be perfectly correlated. If Stock A always goes up the same amount that Stock B goes down, they are said to be negatively correlated. In the real world, securities often are positively correlated with one another to varying degrees. The less positively correlated your investments are with one another, the better diversified you are.
Building a diversified portfolio is one of the reasons many investors turn to pooled investments—including unit trusts. Pooled investments typically include a larger number and variety of underlying investments than you are likely to assemble on your own, so they help spread out your risk. You do have to make sure, however, that even the pooled investments you own are diversified—for example, owning two unit trusts that invest in the same subclass of stocks won’t help you to diversify.
With any investment strategy, it’s important that you not only choose an asset allocation and diversify your holdings when you establish your portfolio, but also stay actively attuned to the results of your choices. A critical step in managing investment risk is keeping track of whether or not your investments, both individually and as a group, are meeting reasonable expectations. Be prepared to make adjustments when the situation calls for it.
Investing for different time periods
Part of setting investment goals is determining when you will need the money to pay for them. Your investment strategy will vary depending on how long you can keep your money invested. Most goals fit into one of three categories—short-term (less than three years), medium-term (three to ten years) and long-term (more than ten years).