An investment strategy is key in limiting your financial risk. It's recommended that you spread your wealth out across a variety of investments, something known as portfolio diversification. If you're already an investor, you know that market conditions change over time and some investments in your portfolio will outperform others.
Two ways to diversify
You can spread your investment funds across and within asset classes to make sure you are well diversified.
- Among asset classes – You can spread your money across the three major asset classes (stocks, bonds and cash equivalents). This is known as asset allocation.
- Within an asset class – You can spread your money across various investment options within a particular asset class (such as large companies and small companies in the stock market). This helps you balance the risks and rewards of the asset classes and the investment within the asset class itself.
How do you decide where to diversify?
Your level of risk tolerance and the amount of time you have before you need the money will help you decide what percentage of your portfolio to assign to each asset class. Depending on your age, risk tolerance and your other assets, your investor profile might be described as aggressive, moderate or conservative or someplace in between.
- Moderate investors – These investors might place a significant percentage of their portfolio in stock or stock funds and the rest in bonds, bond funds or other fixed income investments. The percentage assigned to the equity asset class could be divided among different segments of the equity market, ranging from large companies to small companies or domestic to international.
You should note that funds that invest internationally involve risks not associated with investing solely in the U.S., such as currency fluctuation, political risk, differences in accounting and the limited availability of information. Small company funds involve increased risk and volatility. Bond funds are subject to the same interest rate, inflation and credit risks that are associated with the underlying bonds owned by the fund.
- Aggressive investors – The more aggressive an investor you are and the longer you can leave your money invested, the more you might consider diversifying your investments among more volatile investments like stocks and bonds.
- Conservative investors – If you're a more conservative investor and have a shorter time to invest, you might consider diversifying your money among less aggressive investments like bonds and cash equivalents.
Only you can decide which options to choose and how much you spread your money around. With a diversified mix of investments, you may be better able to ride out the downs of economic cycles and limit the risk to your investment portfolio while seeking the growth you want.
Diversification and asset allocation do not assure a profit or prevent a loss in a down market.