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
Using diversification
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).
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