Global stock markets have had to digest a full plate of unsettling events this summer - everything from the North Korean missile tests and the renewed conflict in the Middle East to a new terrorist plot to bomb aircraft. It certainly would not be unusual for events such as these to increase uncertainty among investors who may be already concerned about the direction of economic growth, corporate profits, inflation and interest rates.
So what can investors do? Worrying about what may happen next won't do any good. Nor will darting in and out of the market to buy or sell investments based on daily market moves. The danger is that you enter or exit at the wrong time, missing the market's best days. A better solution is to stick to a long-term plan. While there's no foolproof strategy to protect against market dips, asset allocation and diversification are two techniques you can use to cushion your portfolio from the inevitable bumps in the road. With that in mind, here's a review of these important strategies.
Managing Risk with Asset Allocation
As you may know from experience, the process of developing an investment portfolio starts by clearly identifying your goals, assessing your tolerance for risk and understanding the risks and potential rewards associated with different investments. Asset allocation and diversification are the fundamental tools you use to control risk in implementing your strategy.
Asset allocation provides the framework for your portfolio. It is the percentage of money you decide to invest in stocks, bonds, cash equivalents and other asset classes you may own. Asset allocation is based on correlation, the degree to which two assets perform the same - or different - under particular market circumstances. In practice, spreading money among asset classes that have historically demonstrated different risk/return characteristics aims to reduce a portfolio's overall exposure to risk while maintaining its return objective. Research has shown that asset allocation may be the single most important factor in determining the variability of long-term portfolio returns.
In addition to diversifying among asset classes, diversification within each asset class attempts to improve a portfolio's risk-adjusted return by reducing exposure to single-security risk - that's the risk that a portfolio's value will fluctuate widely due to changes in the price of one holding. Diversifying across a range of securities creates the potential for better performers to compensate for poor performers. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk.
Your holdings may be diversified by type, such as government, corporate and municipal bonds, and by style, such as growth and value and small- and large-cap stocks. You can also diversify by economic sector and industry and by owning foreign securities as well as domestic issues.
Mutual funds can be helpful in this regard. Because they hold baskets of securities, such pooled investments potentially provide greater diversification than a mix of single securities, although the degree of diversification varies depending on each fund's investment strategy. A fund that replicated a broad market benchmark, such as the S&P 500, would provide greater diversification than a fund specializing in one sector of the economy. Value will fluctuate with market conditions and may not achieve its investment objective.
Resolve to Review
While asset allocation and diversification should help smooth some of the market's volatility, you can't simply put your portfolio on autopilot. Your investment strategy will need to change as you near the destination of one goal, reach another, and perhaps add a new goal. That's why you need to confirm with your financial advisor if your personal situation changes or your goals change. That way your advisor can help evaluate if the risk profile and asset allocation of your portfolio is still the right fit. You should periodically assess whether your investment mix still meets your targets for risk and return. When you do, also take a look at the effect that differences in market performance have had on your asset allocation. If the allocations have strayed far from their targets, you may want to consider rebalancing to bring them back into line. Your financial advisor can help you analyze the current risk and return potential of your portfolio as well as discuss any changes you may be considering.