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Asset Allocation
The Importance of Diversification
By David Smyth
Senior Partner, Family Financial Partners
Diversification is a tool used by financial professionals to help
investors create a portfolio focused on achieving their goals
and dreams, without exposing them to undue risk.
Diversification assists in creating balance in an overall
portfolio and may alleviate the potentially drastic highs and
lows of a portfolio focused on only a few investments. This
balance helps to keep individuals focused on investing for the
long term.
A diversified portfolio is created through the process of asset
allocation. Spreading assets among major investment
categories helps to create balance because each asset class
has different levels of return and risk, and so each will
perform differently over time. The idea is to choose asset
classes that are not directly correlated to one another,
thereby reducing overall risk. While one asset class may be
decreasing in value, another may be increasing.
Think of your portfolio as a pie and that each slice represents
an asset class. One slice may be stocks, another bonds and
another real estate. If real estate is performing well, then
bonds may not be doing as well and the value of stocks may
be decreasing, or vice versa. By diversifying your portfolio
across these various asset classes, you are reducing the risk
that the performance of your portfolio is dependent on the
performance of any one asset class.
Every individual’s portfolio is different based on factors such
as goals, life style, risk tolerance, stage of life, and
investment horizon. In general, the more risk you are willing
to take, the greater the potential return on investment. The
first step in creating an asset allocation model that is right for
you is to evaluate your personal goals, financial situation and
level of risk tolerance. This can be a complex exercise and
many people find that meeting with a financial professional
and reviewing their goals and expectations can be helpful.
Once you and your financial advisor have determined an
asset allocation model that is right for you, consider the
following guidelines when evaluating investment opportunities
to add to your portfolio.
Focus on choosing multiple, uncorrelated asset classes, each of
which act differently during the same market conditions. This
does not mean simply adding to the sheer volume of investments
in your portfolio. Many investors fall into the trap of believing that
they have a well-diversified portfolio merely because it is
comprised of a large number of individual investments.
Choosing from among a variety of asset classes of individual
stocks or mutual funds (for example: value, growth, large-cap,
small-cap, mid-cap or international) is important; however, it may
not provide enough diversification since the overall asset class
(stock or mutual fund) is the same. In this example, adding fixed
income securities or real estate, as separate and distinct asset
classes which act differently than the asset classes of stocks or
mutual funds, can provide a valuable amount of diversification.
Since it is very difficult to predict how the overall market will act
over time, or to predict which asset class will be in favor at any
given time, spreading your investments over a variety of asset
classes gives you a better chance at achieving more stable, longterm
returns.
It is also important to evaluate the sponsor or manager with whom
you are investing. Make sure discipline is maintained within the
asset class represented. And it is worthwhile to review prior
performance and the ability to meet investment objectives. Keep
in mind, there is always the risk that a single sponsor may not
meet its objectives, thereby reducing your portfolio’s return. By
spreading this risk across more than one sponsor or manager,
you can potentially moderate the negative impact that a single,
underperforming investment may have on your portfolio.
Diversification alone will not ensure a profit or guarantee against a loss in a portfolio. Like all investments, real estate securities in general may be subject to various risks including credit risk, interest rate risk, the risk that the value of the underlying properties may decline, and risks related to a general economic or market decline.
Securities offered by David E. Smyth, Registered Representative, through: The O.N. Equity Sales Company, Member NASD/SIPC, One Financial Way, Cincinnati, OH 45242 513.794.6794
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