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Asset allocation: Diversification is king

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The king and you

Invest in different asset classes, across geographies, sectors and styles, and the impact of any one investment on your portfolio is diminished. Most investors, especially new investors, worry about poor performance but forget about the importance of diversification.

For example, if your only investment is your house, then you’re not very diversified. Ask anyone who was overloaded in U.S. residential real estate about how lack of diversification can negatively affect your portfolio.

These days diversifying is easier than ever. You can invest in real estate, international stock and bond markets, emerging markets and commodities. You don’t have to simply depend on domestic stock and bond markets as much as investors once did.

But what is important is considering the risk/reward features of these asset classes. You don’t want to invest too little or too much in any one asset.

The challenge of asset selection

The number of investments available today is truly staggering. Individual stocks and bonds, mutual funds, ETFs and managed accounts are only a few of the types of investment options. If you want to manage risk well, you have to evaluate how each investment will impact your portfolio.

Benchmark indices help financial professionals gauge the performance of their assets under management. Some investments are designed to very nearly track these indices. Many exchange-traded funds seek to offer investors nearly the same performance as indices.

Individual securities or actively managed funds hold out the potential to outperform the indices they are based on. However, these investments rarely do outperform. And they often carry higher risk and higher management fees that are a detriment to an investor’s overall portfolio depending on the extent of an investors understanding of markets, and the level of advice she may need.

Determining the level of risk you are comfortable with is crucial. Mixing index and active investments into your portfolio will benefit you when it comes to the end result of achieving your objectives.

Rebalancing

Rebalancing your investments is key. Periodically, investors should review their portfolios and re-assess their investments and long-term goals. Often, this requires selling your best-performing investments along with the discipline to execute your plan.

“Buy low and sell high” may be the mantra investors want to follow, but for many, it’s easier said than done. Risk management best practices suggest that an investor must pay just as much attention to selling high as buying low. Getting overly greedy after a good run in the markets is dangerous to your portfolio.

By rebalancing, you can stay on track. Proper asset allocation helps you stick to your risk/return objectives. Although this sounds easy on paper, it’s not. Systematizing the rebalancing process is one of the most important processes of a sound investment plan.

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How to be a smarter investor

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Most people obsess about investment performance. While tracking the performance of your investments is without a doubt important, are you considering risk?

Investors generally understand risk. For example, not meeting investment goals stands out as a hazard when it comes to portfolios. But without risk, there is no return. You have to take some risk to earn better-than-average returns.

So, how should you consider risk? How does risk fit into your portfolio? If risk and reward are so heavily correlated, how much should you be taking? How can you manage risk properly?

Understand risk

What is risk, anyway?

You can’t control everything. The recent market meltdown was out of investors’ control. But how you organize your portfolio is within your control. And that’s empowering.

Most Americans investing in residential real estate didn’t think they were taking on a lot of risk. Yet U.S. residential real estate dropped by about 50 per cent from its peak. You definitely increase your risk with all your eggs in one basket. But you can manage risk. You can create less uncertainty and the stronger probability of meeting your investment goals.

Are you taking on too much risk? Is there overlap in the securities or funds you hold? You think you’re well-diversified, but are you really? On the other hand, if you’ve been holding only low-risk, low-return investments like GICs over the last ten years, you might feel sorry. Why? Because if you held a basket of Canadian financials (even with two major stock market corrections), you would still come out ahead. Yes, risk offers the potential for higher returns. However, you need to determine what the appropriate amount of risk in your portfolio is.

In order to create an intelligent investment plan, you need to evaluate your risk tolerance. You need to ask yourself questions like … How much risk are you willing to take? Is a very conservative strategy going to allow you to achieve your investment goals? Research shows that being too conservative also entails risk when it comes to achieving portfolio goals. Risk is not only about aggressive investments. Conservative investments carry risk, too.

Risk, by any other name, is still risk

Risk can take many shapes and forms. Do you have the right investments? Are you being too aggressive? Or maybe you’re not being aggressive enough? The best way to consider risk is by having a sound investment plan.

Considerations for your investment plan

• Asset allocation

• Choosing assets that will make up your allocation

• Rebalancing your portfolio

In an upcoming post, I will discuss the above fundamentals.

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