Investing 101: Portfolios And Diversification
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It's good to clarify how securities are different from each other, but it's even more important to understand how their different characteristics can work together to accomplish an objective.
A portfolio is a combination of different investment assets mixed and matched for the purpose of achieving an investor's goal(s). Items that are considered a part of your portfolio can include any asset you own - from real items such as art and real estate, to equities, fixed-income instruments and their cash and equivalents. For the purpose of this section, we will focus on the most liquid asset types: equities, fixed-income securities and cash and equivalents.
An easy way to think of a portfolio is to imagine a pie chart, whose portions each represent a type of vehicle to which you have allocated a certain portion of your whole investment. The asset mix you choose according to your aims and strategy will determine the risk and expected return of your portfolio.
Basic Types of Portfolios
In general, aggressive investment strategies - those that shoot for the highest possible return - are most appropriate for investors who, for the sake of this potential high return, have a high risk tolerance (can stomach wide fluctuations in value) and a longer time horizon. Aggressive portfolios generally have a higher investment in equities.
The conservative investment strategies, which put safety at a high priority, are most appropriate for investors who are risk averse and have a shorter time horizon. Conservative portfolios will generally consist mainly of cash and cash equivalents, or high-quality fixed-income instruments.
To demonstrate the types of allocations that are suitable for these strategies, we'll look at samples of both a conservative and a moderately aggressive portfolio.
Note that the terms cash and the money market refer to any short-term, fixed-income investment. Money in a savings account and a certificate of deposit (CD), which pays a bit higher interest, are examples. (You can read more about the money market in the Money Market Tutorial.)
The main goal of a conservative portfolio strategy is to maintain the real value of the portfolio, or to protect the value of the portfolio against inflation. The portfolio you see here would yield a high amount of current income from the bonds and would also yield long-term capital growth potential from the investment in high quality equities.
A moderately aggressive portfolio is meant for individuals with a longer time horizon and an average risk tolerance. Investors who find these types of portfolios attractive are seeking to balance the amount of risk and return contained within the fund.
The portfolio would consist of approximately 50-55% equities, 35-40% bonds, 5-10% cash and equivalents.
You can further break down the above asset classes into subclasses, which also have different risks and potential returns. For example, an investor might divide the equity portion between large companies, small companies and international firms. The bond portion might be allocated between those that are short-term and long-term, government versus corporate debt, and so forth. More advanced investors might also have some of the alternative assets such as options and futures in the mix. As you can see, the number of possible asset allocations is practically unlimited.
It all centers around diversification. Different securities perform differently at any point in time, so with a mix of asset types, your entire portfolio does not suffer the impact of a decline of any one security. When your stocks go down, you may still have the stability of the bonds in your portfolio.
There have been all sorts of academic studies and formulas that demonstrate why diversification is important, but it's really just the simple practice of "not putting all your eggs in one basket." If you spread your investments across various types of assets and markets, you'll reduce the risk of catastrophic financial losses.
Next: Investing 101: Conclusion »
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