Diversifying Your Investment Portfolio

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Thanks so much for your questions and responses to this column. It seems as though there is not a lot of information out there for domestic partner planning.Your responses to the previous column overwhelmingly requested me to slow down a bit, and get back to financial-planning basics. Below you will see the four cornerstones of investing, which together can be the foundation for creating a personal investment strategy.

1. Define Specific

2. Diversify Among Investment Types

3. Stay Invested

4. Periodically Review Your Portfolio

We started with the first cornerstone, defining specific goals in the L Style column, and will continue here with the second cornerstone, diversifying among investment types.

CORNERSTONES OF INVESTING

DIVERSIFYING AMONG INVESTMENT TYPES

Investing in a variety of asset classes and investment styles can be a useful risk-management tool. Diversifying among different types of investments, which may respond differently to various economic and market conditions, can help reduce volatility in your portfolio.

Over time, various types of investments tend to perform differently. By investing in a variety of asset classes, such as stocks, bonds and cash, you can help reduce your exposure to a downturn in any one sector. In fact, a 1991 study of large pension funds showed that more than 90 percent of the variation in portfolio performance could be attributed to asset allocation. Security selection determined just 5 percent of performance, and market timing, just 2 percent. Rebalancing alone does not ensure gains or prevent losses from occurring in a portfolio or account.

Here’s a quick example of a basic diversification strategy of holding both stocks and bonds in a portfolio. For most of the last decade there have been significant differences in annual performance.

For example, in 1999, the S&P 500 Index rose 21.04 percent while the Lehman Long Government and Credit Index lost 7.65 percent. On the other hand, in 2002, the S&P 500 declined 22.10 percent, and the Lehman Index was up 14.81 percent.

So what is the ideal asset mix? A portfolio that is well diversified will hold assets that do not all react the same way to econom- ic and market cycles and world events. Stocks, bonds, cash – perhaps even commodities and real estate – can be considered, depending on your goals and risk tolerance. One thing is clear: Maintaining a diversified portfolio can potentially reduce overall volatility by balancing ups and downs in different areas. That is even true for different sectors within the same asset class. The chart below demonstrates how one year’s top performer can be next year’s laggard.

 

 

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