Why diversification is key: Balancing the ups and downs in the financial markets.

If you had to choose one word to sum up a balanced portfolio, it would probably be diversification. Anyone looking to make as much money as possible might consider putting all their money into equities, which have been among the best-performing asset classes over the long term. The trouble with this approach is that stocks tend to be one of the most volatile asset classes and can plunge in value in short periods of time.

Another investor might look at the volatility that equities involve and decide they don’t want any part of it. So they choose to invest all their assets in government bonds, which have historically provided much smoother returns, instead. The problem with this approach is that a government bond portfolio is likely to rise considerably less than stocks over the long term.

The option that many investors choose, therefore, is to combine equities and bonds to produce a balanced portfolio. The beauty of this approach is that if equities fall over a given period, there’s a good chance that government bonds will rise in value as equity and bond returns have a low correlation with each other – in other words, the two asset classes don’t tend to rise and fall at the same time. In fact, diversifying your investment portfolio in the right way could potentially reduce its volatility without sacrificing its return potential.

How your investor profile affects your portfolio’s structure

You know that you need to diversify but you still need to decide how much to allocate to each asset class – what’s the best option?

Every investor has a different tolerance for risk, which is one of the most important factors in shaping a balanced portfolio. Your risk tolerance depends on your financial situation, investment goals, how willing you are to accept volatility and your investment horizon. It’s also important to make an honest assessment of your level of investment knowledge and take that into account. 

Three main investor profiles include:

• Income: Your main concern is that you don’t want your assets to fall in value. If that’s the case, you’ll need to accept that there will be limited scope for your portfolio to increase in value. This investor portfolio mainly consists of low-risk assets.
• Balanced: These investors generally choose a mix of low- and high-risk assets. If you fall into this camp, you’ll need to accept that you’re unlikely to achieve stellar returns and that there may be periods when your assets fall in value. Investors looking for regular income from interest and dividend payments often fit into the balanced risk profile.
• Growth : These investors are most willing to invest in higher-risk assets to grow the value of their assets and accumulate wealth over time. The downside is that their portfolio could fall in value significantly in the shorter term.

What does a balanced portfolio look like?

Once you’ve determined your investor profile, it’s time to work out your exact asset allocation. In the chart below we show possible asset allocations for the three investor profiles we discussed above. As you can see, the capital preservation portfolio is predominantly invested in bonds and the dynamic growth portfolio in equities. The balanced risk portfolio sits in the middle.

These are what we call strategic (in other words, long-term) asset allocations. Many investors choose to base their portfolio on a strategic allocation but make changes to it within predefined limits based on expectations for different asset classes. This process is called tactical (shorter-term) asset allocation. For example, if you have a 50% weight to equities in your strategic asset allocation, and the stock markets have been performing poorly but you expect them to recover soon, you might choose to increase your equity allocation to 55% over the short term to benefit from equities having become more attractively valued. 

Meanwhile, market movements can cause your asset allocation to change over time. For example, if stocks perform well, it’s likely that their proportion within your portfolio increases. For this reason, it’s generally a good idea to rebalance your portfolio once or twice a year or whenever it’s moved a long way from target levels to bring it back in line with the intended allocation. The main reason to rebalance is to manage risk exposures rather than increase return potential.

You can increase the benefits of diversification by investing in more asset classes than just equities and government bonds. Popular options include real estate, commodities (most notably gold), and cash. For some investors, more sophisticated alternative investments, such as hedge funds and commodities, could also be an option.

And you can further improve your overall balanced portfolio’s level of diversification by spreading your investments within each asset class. This might involve, for example, investing in equities and government bonds from different regions rather than just your home market. Within equities, it could also involve investing in small as well as large companies. 

Align your portfolio to your personal life situation

Finally, it’s important to remember that your investment goals are likely to change over time, and it’s almost certain that your investment horizon will. That means you shouldn’t stick to the same strategic asset allocation forever. 

Many young investors are willing to invest aggressively in high-risk assets to maximise their portfolio’s growth as they have time to make good any slumps in value. Older investors, however, often look to shift into lower-risk asset classes like bonds as they don’t want their portfolio to plunge in value just before they retire. 

Don’t forget to reassess your goals periodically to make sure your balanced portfolio is still matching your needs.