Building a Solid, Well Diversified Portfolio
Most of us understand the concept of taking a balanced approach to life. For example, rather than choosing between either eating anything you want all the time or exercising 24 hours a day, the accepted wisdom is to strike a balance between the two. If you watch what you eat and incorporate exercise into your routine, you will probably enjoy a greater quality of life than someone who leans to either extreme.
When it comes to optimizing your portfolio, the theory of taking a balanced approach is also a good one to take. A balanced collection of funds will usually help you meet your financial goals better than investing in the latest, trendy fund. When you are developing an investment plan which is centered around mutual funds or exchange-traded funds (ETFs), you should get away from the idea of investing in a single fund or ETF and think more in terms of your overall portfolio. If you incorporate a number of mutual funds or ETFs of different varieties – between, say, four and nine – your portfolio should be diversified to a decent level.
A strong, diversified portfolio which balances stocks, bonds, alternative investments and cash could be one of the most important tools in your investment toolkit. As a rule, your selection of assets has more to do with your ultimate return on investment than with the specific issues you choose.
When you are deciding how to break down your allocation of stocks and bonds, you should consider a couple of things. What is your time horizon? If you foresee a long time between making an investment and when you will need to draw on the money, you can afford to invest a larger amount in stocks.
First, how much time will pass before you need the money? The longer your time horizon, the more you can afford to invest in stocks. If you are looking at retiring ten or more years from now, you should consider placing a substantial portion of your assets in stocks. If you are looking at making a substantial investment in five years – say a down payment on a house or paying for college tuition – you should probably think about placing about half or less of your portfolio in stocks.
You should also determine your tolerance for volatility and risk. You should be comfortable with the market’s short-term downturns if you hope to reap the benefits from its potential for positive long-term results. If you are the type of skittish investor who sells your stocks every time they drop by a significant percentage, you are more likely to return to the market only after stocks have rallied back. When you are choosing stock funds, your first decision should be how much to allocate to United States stock funds and how much should go toward funds which specialize in overseas stocks. Furthermore, international funds can be distinguished further by whether they invest in the stocks of developed countries (i.e. France, Germany) or in emerging market economies (i.e. Brazil, China). Since the U.S. represents half of the world’s stock market capitalization, it seems reasonable to invest anywhere from 15% to 50% of your stock portfolio in overseas issues.
When it comes to domestic stock funds, one diversification technique involves choosing an outstanding fund from each of three categories: aggressive long-term growth, growth and growth and income, making sure you do not choose funds which own the same kinds of stocks. If you have a long time horizon and a high tolerance for risk, you should consider allocating more of your money to an aggressive fund. If the reverse is true, you can consider the growth and income fund.
The most important decisions regarding bond funds involve the maturities of bonds they own and the quality of those bonds. As a rule, the longer a bond’s maturity, the more it yields. Of course, longer maturities also mean greater risks. Generally, the more a bond approaches “junk” status, the higher its yield. Of course, the value of lower quality bonds may fall if investors foresee more difficult times ahead for their issuers, or the economy as a whole. Right now, the Federal Reserve have indicated that interest rates will remain low in the United States for the next few years, however bond investors will need to start thinking about positioning their bond portfolios for higher interest rates.
Please consult with your financial advisor to discuss your various options and how to best position your portfolio to balance your risk tolerance level with your financial needs.
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