Speculation about the future, specifically the impact of wars, acts of terrorism, unemployment, interest rates and even natural disasters, shapes individual levels of investment risk.
While you can’t control these events, you can do something about protecting your investments. For most investors, the key to investing in uncertain times is diversification.
Market ups and downs
The variation seen in the prices of financial instruments is a central feature of financial markets today. Some of the market volatility has to do with the overall market, such as concerns about changes in interest rate policy. Markets can also move when a certain sector, such as oil, is affected by important news. Investors should prepare to see a lot of ups and downs in the markets over their lifetimes, but the decisions they make when the market is down can prove to be the most costly.
Even though statistics show that stocks and bonds are good investments over the long haul, investors are not easily comforted by statistics when they experience significant losses. During times of uncertainty and increased risk, it is difficult to remain invested in the markets. Investors must decide whether to persevere until the market improves or pull their money out and place it in the safety of a traditional, low-risk savings account.
Selling after the market crashes may be the single worst mistake an investor can make. The historical overall long-term trend of the U.S. stock market has been upward, so investing for the long-term makes sense.
Diversification will always be a critical component to investing wisely, especially during dubious times. As recent events have shown, you run the risk of losing some or most of the money that you invest. Diversification limits this risk while increasing the potential to earn attractive returns in any type of investment.
The reason that many investors often do not have a clear understanding of the importance of diversification has to do with the avoidance of investment correlation. One of the greatest risks any portfolio faces is that similar or closely related developments or economic forces will affect the composition of its investments.
For example, suppose an investor puts together a portfolio that is broadly diversified across the U.S. stock market. What happens if the United States suffers an economic slowdown or is hit with a recession? That portfolio, although diversified in the U.S. market, will likely experience price declines because its investments are correlated.
Although this investor’s money is not all in one stock, bond, mutual fund or other financial instrument, all of the money is concentrated in one market. Hence, the portfolio contains investments that will move together.
Avoidance of this investment correlation is at the core of asset allocation plans. When you use asset allocation, you allot a percentage of your investments to each major asset class, based on your personal investment profile. The goal is to get the highest returns possible at the level of risk with which you are most comfortable.
To be effective, asset allocation plans must contain multiple components/assets that do not move up or down together. With this strategy, investors can expect to maintain overall long-term portfolio returns while reducing portfolio risk.
This is true even if the assets investors add to their portfolios are more volatile in the short-term than the portfolio as a whole. Past performance is not indicative of future results.
Diversification and asset allocation are time-tested ways to balance risk and return. The ability to reduce risk is the real advantage of diversification. The key is deciding on your own diversification strategy based on your goals, investment timeframe and risk tolerance, and implementing it by building and maintaining a diversified portfolio.
Take the time to review your portfolio to ensure that it is allocated in a way that will get you through uncertain times and help you reach long-term objectives.