Understanding investment diversification
In my columns of Aug. 18 and the 25, I went into some detail about asset allocation. Deciding how to apportion your financial assets – equities, fixed-income securities and cash equivalents – in your total portfolio is the most important investment decision you’ll make. It defines your overall risk-return position, which guides you through a lifetime of investing. Your next step, investment diversification, is a close second when it comes to making key investing decisions. This process involves the thoughtful selection of a variety of securities and/or mutual and exchange-traded funds that are suitable components for your chosen asset classes.Because asset allocation and investment diversification are often confused in investment literature, it’s worthwhile pausing here to explain how these two differ. Using a culinary metaphor, I suggest you think of asset allocation as deciding the basic nature of a meal – the appetizer, the entree and dessert. Investment diversification then involves deciding on the various choices available for choosing the components of these main courses.Asset allocation is your “master plan.” Investment diversification spreads out the risk and returns inherent in your asset class choices among a suitable variety of different investment categories. This process is often referred to as “risk management.” But, since we know that risk and return are commensurate, it also provides for “return management” by providing for a diversity of investments selected for their expected performance, reliability, growth potential and financial strength. There are several investment categories to choose from, and it is here that many individual investors become confused. Stocks and bonds, and their counterpart mutual funds, are generally categorized according to the size of the company (large, medium and small), industry sectors, geographic location, and investment style or objective (growth and value or a blend of both). Each investment category has differing investment qualities associated with it. Sorting out all these choices can be a daunting experience for the less-experienced investor. If you need the help of an investment professional to make informed decisions, make sure you understand what’s being recommended and the advisory and/or purchase costs involved.Using mutual funds for investment diversification is easier than investing directly in stocks and bonds. The latter requires expertise, experience and time to undertake this task successfully. ‘By definition, a mutual fund – let’s say, a large-cap (large size company) growth stock fund – will be additionally diversified by holding dozens, if not hundreds, of companies in its portfolio. And, you get professional investment management and research on a continuous basis.Another way to make the investment-diversification process relatively easy is to use index and exchange-traded funds that cover broad market segments. For example, several investment firms offer an index fund that is comprised of all the companies in the Standard & Poor’s 500 Index. The monies in this type of fund would be apportioned, according to market-capitalization, among 500 large U.S. companies covering 23 industry sectors. Also, you can capture the whole U.S. stock market – over 5,000 large, medium and small companies with value, growth and blended investment styles – in a single fund that tracks the Dow Jones Wilshire 5000 Index. This category’s fixed-income equivalent would track hundreds of bond types that comprise the Lehman Brothers Aggregate Bond Index.Lastly, so-called lifestyle or target funds are multiple funds wrapped into a single fund that promises lifetime, automatic asset allocation and diversification in one easy-to-manage package. I have some reservations about this one-size-fits-all approach, but it is better than doing nothing or piling into dozens of investments without a coherent plan.The key to successful investing is to manage risk while generating a reasonable return on your investment portfolio. Proper asset allocation and investment diversification are the primary tools to accomplish this goal. The Investing Wisely column is written by Richard Loth, managing principal of Mentor Investing and an independent registered investment adviser. Loth can be reached at 328-5591 or firstname.lastname@example.org.Vail Colorado
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