- Posted by NateKragness on December 4, 2009
The basic premise of a diversified portfolio is that you don't want to cripple yourself with any single loss. By keeping a variety of investments, you minimize the risk of all of them, as even a market-wide crash will only affect a portion of your total portfolio. Furthermore, by spreading your money out over four specific investment classes, you are able to ensure the overall health and growth of your portfolio. These asset classes work in symbiosis, providing a collective growth that is greater than the sum of their individual parts. By protecting your assets with diversification, and maintaining each of these four asset classes, you ensure that your total portfolio continues to grow, even in spite of any individual losses.
There are four main components to a balanced portfolio: aggressive growth, low-risk growth, preservation of capital, and cash flow investments. By tailoring these to your own personal goals and risk tolerance, you can create constant growth and generate an increasing income from your portfolio. Imagine that your portfolio provides you a paycheck every day, and each day it’s larger than the last, but the portfolio never goes down in value. This should be your main goal for a well-balanced portfolio, as your assets will continue to grow all throughout your retirement years. Each step has an important role in the overall portfolio, and can be customized based on your own personal motivations.
- Aggressive Growth: This highly-volatile component bears the most risk, but also provides opportunities for exponential growth of your investments. For example, if you have a 50-50 chance to triple your money, this would be considered an aggressive growth investment, because it’s likely that you could lose your entire investment. However, it’s actually a very prudent (but high-risk) investment, as you have an equal chance of massive returns, provided you have sufficient tolerance for risk. In fact, your expected value from this investment would be a 50% return on your money over time, since you would either lose your investment (half of the time) or triple your investment (the other half of the time). In other words, suppose you had two separate opportunities to invest $1,000 in this opportunity. Statistically, you will lose your full investment of $1,000 on one transaction, and turn your other $1,000 into $3,000 on the second investment. Your net result would be $2,000 invested, and $3,000 returned, for a total profit of $1,000, or a 50% gain on your total investment. This is considered an aggressive investment, however, because each individual transaction has a high probability of catastrophe. In the above example, it's quite possible that you would lose $2,000 -- it's equally possible that you would gain $6,000! Aggressive growth doesn't mean you have to take on unwarranted risk; you should still make sound investments, but these investments will tend to have much higher default rates than the rest of your portfolio. This isn't a cause for concern at all, at least within a well-diversified portfolio, since your overall gains will rise faster than any individual losses. The primary role of aggressive investments are to spearhead the growth of the entire portfolio, and without at least some aggressive growth, your will be crippling the growth of your overall portfolio.
- Low-Risk Growth: Here, the objective is to provide moderate growth over time, but also to avoid capital loss. In other words, you want to avoid the volatility inherent to aggressive growth, but still increase capital at a rate that exceeds inflation. Risks should be very mild, and returns are likely amortized over many years, but consistent and reliable. These dividends help to fund the overall expansion of the portfolio, and steady, consistent gains have an incredibly propensity to compound over time. Both aggressive and low-risk growth are important to every portfolio, but your own tolerance for risk, and your timeframe for the investments, will dictate exactly how you want to balance these ratios. Someone in their early twenties would likely only want a very small percentage of their assets in low-risk growth, and a much larger percentage in aggressive growth, since they have plenty of time to weather market fluctuations. On the other hand, an investor who is already well into their retirement would want the majority of their growth assets to be allocated in more conservative investments, for exactly the same reason -- as one ages, importance begins to shift from capital growth to capital preservation. It is important to note, however, that regardless of your age, it would be highly unusual--and almost always quite imprudent--to avoid aggressive growth entirely.
- Preservation of Capital: By having a portion of your assets insulated from volatile market forces, you ensure that there are funds available to invest during market downturns. This allows you to become a capitalized opportunistic investor, and to take advantage of the incredible deals available during down markets. For example, as the housing market declines, the buying power of your preserved capital increases in that market. In other words, you are able to buy a lot more house in a down market than you could in the midst of an appreciating market. If you have the funds available to purchase assets that are artificially deflated due to market conditions, and still have underlying value, you will be able to make excellent investments when banks might not be lending money. This works equally as well in the stock market -- during a recession or depression, it's not uncommon to see a strong company's stock "on sale" for what essentially amounts to 50-75% off. The value of the company has not significantly changed, but the price has been depressed by the economy. If you thought it was a smart investment at full price, it's an exceptional investment at a steep discount. By ensuring that you always have a portion of your portfolio preserved, irrespective of what the markets are doing, you guarantee that you will have funds available to take advantage of incredibly opportunities only available to cash buyers. These types of investments often provide substantial gains at almost no risk, and are only made available by keeping some of your funds preserved. In other words, preservation of capital -- the cornerstone of the portfolio -- measures your consistent economic growth, and allows for value investing during down markets. This portion of your portfolio should always be increasing over time, and provides a good snapshot of where your entire portfolio stands at any given moment.
- Cash-Flow Investments: Often comprised of stocks that provide dividends, these investments produce a regular income over time, which helps to both offset recurring liabilities, and fund recurring investments; with solid cash flow investments pumping money back into your portfolio, you ensure constant and stable growth over time. For example, suppose you make a one-time investment of $20,000 into a real-estate investment trust (REIT), a vehicle known for producing reliable cash flow, that pays out a dividend of $100 per month (about a 6% annual return). Then, you set up an automatic investment with your broker to purchase $100 of stock every month in a high-growth index fund. Suddenly, you have created an investment that will continue to grow over time, without any additional work on your behalf. Your initial capital is generally preserved, and you use the dividends to purchase another asset class with more potential for growth. The same investment is essentially working for you twice, and is well-diversified. Another strategy for cash flow is to build up your passive income such that it exceeds your basic living expenses. Instead of thinking of your retirement needs in terms of a total portfolio amount, consider how much money you need to replace your income. If you can build up your investments to provide a steady stream of income every month, your portfolio is large enough to support you indefinitely. Of course, your goal should be to exceed your monthly expenses so that you can apply the surplus to additional investments, such that your disposable income grows each and every month. Once you are at a comfortable level of income, you can stop investing new funds and the portfolio can maintain itself forever. You are effectively retired, and your income will continue to grow every year. You don't need to have millions of dollars in your portfolio before you can comfortably retire -- you just need enough income from your investments to pay your expenses.
It is important to note that the specifics of how you invest in each asset class are not discussed in this article. For example, the aggressive growth portion of your portfolio might be comprised of a blend of domestic and international stocks, peer-to-peer loans, speculative investments in businesses, etc. By the same token, your preservation of capital portion might also contain international stocks. In other words, just adding international stocks to your portfolio doesn't adequately diversify it -- if your total portfolio is comprised of domestic low-risk investment funds, and you purchase some international low-risk investment funds, you have perhaps succeeded in diversifying that specific investment class, but your total portfolio is not properly diversified. You should strive to spread assets over all four of these classes first, above and beyond worrying about diversifying each one individually. No matter how much you diversify your low-risk growth, if you fail to provide sufficient aggressive growth stocks, your entire portfolio will suffer. By the same token, if you have mostly high-growth stocks, but neglect your preservation of capital, you will lose out in the long-term, since you won't have the funds available to invest in value stocks during a down market. Each asset class has its own purpose, and diversification is critical to the overall health of your capital.
If you aren't comfortable making these decisions about your finances, you should find a fee-based financial planner to help you analyze your tolerance for risk, and your timeframe for investment. But always be mindful of the importance of diversification, and strive to keep a balance between growth, preservation and cash-flow. Ensuring that you keep a diversified portfolio, tailored to your own personal risk-tolerance, will ensure that your portfolio continues to work for you, and it will eventually be able to provide you an income without further investment on your behalf. By properly diversifying, you minimize your investment risks, while maximizing your potential gains.