In finance, there are two types of risk:
Unfortunately, your snowboard friend didn’t tell you that the resort you picked still hasn’t upgraded to the high-speed chairlifts, and they also don’t plow their roads very often. It turns out that while all the other mountains were turning huge profits, your investment actually lost 10%.
The risk associated with the one mountain would be specific risk. The risk of having bad weather would have been systemic risk.
If you had taken your money and divided it up across all of the ski resorts in Colorado, you would be up 15%, but because you happened to pick the one bad egg, you lost money.
The above example explains why investors are often choosing mutual funds and exchange-traded funds (ETFs) over individual stocks and bonds. Mutual funds and ETFs invest in underlying pools of investments specific to a particular investment objective. These objectives can range from specific to one particular industry to something that achieves a balanced portfolio of blended assets.
The idea of eliminating risk by spreading investments across pools of underlying stocks and bonds is called diversification. A diversified portfolio spreads investments across all asset classes with a weighting system that takes time frame and risk tolerance into account. The weight is the proportion of that portfolio assigned to one category. In our example. we talked about diversifying away the risks of slow chair lifts but in reality, there are many more aspects to diversification.
Asset allocation is the theory that any portfolio should have a set of target weights for different asset classes based on time frame and risk tolerance.
There are two key principals at work in this theory.
Suppose we have a portfolio of $100,000 that has a target mix of 60% stocks and 40% fixed income and, therefore, has $60,000 in stocks and $40,000 bonds. The stocks have a good year and bonds have a bad one. Let's calculate what we will have after this year:
Good Year with Stock Return = $60,000 * 15% = $9,000, so a total of $69,000 invested in stocks
Bad Year with Bond Return = $40,000 * 4% = $1,600, so a total of $41,600 invested in bonds.
At this point, we have a total portfolio of $110,600 and an asset mix of roughly 62% stocks and 38% bonds. We began with a target mix of 60-40, but since the equity market fared better than the fixed-income market, we are a little off-balance.
Initial Portfolio Stocks $60,000 60% Bonds $40,000 40% Total $100,000
New Portfolio Stocks $69,000 62% Bonds $41,600 38% Total $110,600
So how do we fix that? We could sit and wait and watch what happens, or we could balance it back to a 60-40 relationship by shifting $2,640 from our equity position to a fixed-income position.
New Portfolio Stocks $66,360 60% Bonds $44,240 40% Total $110,600
Remember, things go in cycles, so we expect that if stocks do well relative to bonds, that sometime in the future, bonds will do well relative to stocks. By shifting $2,640 from our equity position to our fixed-income position, we are essentially selling stocks after they have appreciated (at a high) and buying bonds after they have failed to appreciate (at a low).
Look at how the different asset mixes fare, based on a 10-year period that is consistent with historical averages.
Projected 10-Year Cumulative Return After Inflation|
(stock return 8% yearly, bond return 4.5% yearly, inflation 3% yearly)
|80% stock / 20% bond||52%|
|70% stock / 30% bond||47%|
|60% stock / 40% bond||42%|
|50% stock / 50% bond||38%|
|40% stock / 60% bond||33%|
|30% stock / 70% bond||29%|
|20% stock / 80% bond||24%|
The theory can feature different strategies, including strategic asset allocation, tactical asset allocation, and others, but the ideas are the same as the implications for return. A portfolio should consist of a variety of classes of assets to take advantage of zero and negative correlations between those classes, and it should be designed to achieve a target mix of assets that are rebalanced when one grows in relation to another.
A primary reason for a diversified asset allocation is the fact that markets often sway away from each other, and it can be beneficial to have a portion of your holdings invested in bonds in years when stocks do badly.
Remember that in 2000, the NASDAQ lost 39.28% of its value (4,069.31 to 2,470.52) and in 2001, the NASDAQ lost 21.05% of its value (2,470.52 to 1,950.40). Had your portfolio consisted of a set of stocks that approximated the NASDAQ Index, you would have lost roughly 52% of your portfolio’s value (from 4069.31 to 1950.40).
As mentioned before, there are more than two basic asset classes. Here are some examples of the types of assets that may be included in a diversified strategy:
A diversified portfolio containing investments with small or negative correlation coefficients will have a lower variance than a similar portfolio of one asset type. This is why it is possible to reduce variance without compromising expected return by diversifying.
Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Portfolio Considerations” TUTORIAL.