Asset Allocation With No Reservation

Did you review your portfolio this year?

Before coming into this business, I thought I was diversified by having my investments in a Vanguard S&P500 index mutual fund. I figured. Hey, I’m across 500 stocks, that’s diversification. In reality, all my holdings were in one asset class, large-cap domestic stocks. Real diversification includes many categories of investments including but not limited to small stocks, large stocks, international stocks and bonds.

As far as asset-class winners and losers, the last time large stocks gave the highest return was in 1998. Since then, bonds and international stocks performed better. So why diversify? Winners rotate; you don’t want to miss out on the best performing asset classes.

To reduce the volatility of returns in a portfolio, combine assets that tend to have low correlation to one another.

For example, a rock group needs musicians with different attributes and talents – the group must be diversified. Building a group with four guitar players is not a great idea, as much as we like guitar players. A singer is needed, as well as a drummer. Because they have different attributes and talents, the correlation between guitar player and drummer is low – and low correlation is what you’re after.

Low correlation equals diversification. Economics professor Harry Markowitz summarizes the basic premise underlying diversification and portfolio asset allocation in one sentence: “To reduce risk, it is necessary to avoid a portfolio whose securities are all highly correlated with each other.”

A preferred asset allocation should be based on your investment goals, risk tolerance, age and your time horizon. A portfolio of all stocks or all bonds may not be appropriate for you. A balance of many asset classes is ideal.

About the author

James Shagawat, CFP®, ChFC®, MBA

Jim handles client relationships and provides expertise to the firm on financial planning. He has been providing wealth management services since 2002. He currently serves working families, widows and retirees. Jim has been featured in the Wall Street Journal, Dow Jones Newswire, Bottom Line Personal and MSN Money. Specialties: Fee-Only Comprehensive Wealth Management.

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