A well-balanced mix of investments is a long-term strategy of how you invest your money in different asset classes like stocks, bonds and cash. The purpose is to create stability and progress toward achieving your financial objectives without risking too much at the wrong time, thereby causing serious declines in value. A well-diversified mix is based on managing what you can control rather than trying to forecast the future performance of the market. The intent of this article is to provide guidance for selecting a mix, for including the appropriate components, for maintaining the mix over time through the process of rebalancing and for ensuring that the overall strategy is resilient during periods of significant market fluctuations.
1. Establish the Objective and the Time Horizon
The objective of your portfolio should reflect the reason why you have invested your money. Your mix for retirement may be able to take greater risk than your mix for a short-term objective.
A good foundation begins with three input factors:
- Time horizon: At what time will you need the money (5 years, 15 years, 30 years) .
- Risk tolerance: How much decline in value would you experience before you start panicking and sell?
- Cash needs: Emergency savings and immediate expenses.
Generally, a longer time horizon will allow for more equity investing for long-term growth. Conversely, a shorter time horizon may require more fixed-income securities and/or cash to mitigate possible sharp declines in value.
2. Create the Core Mix Using Simple Asset Bases
A good diversified mix is created by using a few fundamental building blocks that perform differently in both favorable and unfavorable market conditions. Perfect diversification is not a requirement. The goal is to achieve balance.
Common building blocks include:
- Stocks (Equities): High growth potential and high volatility.
- Fixed Income Securities (Bonds): Smooth returns and can reduce volatility in your portfolio.
- Cash/Cash Equivalent Funds: Stable returns and liquidity for meeting immediate cash needs.
- Optional Diversifiers: Real Estate Funds, Inflation Protected Bonds, Commodities.
- A good starting place for a beginning investor is a “Core and Satellite” framework:
- Core (majority of the portfolio): Index Funds for Stocks and Bonds.
- Satellites (minority of the portfolio): Additional Exposure, e.g., Small-Cap Stocks, REITs.
3. Diversifying within Each Asset Class
Diversification is not merely owning “many things.” Rather, it means owning various levels of risk so that one type of risk does not jeopardize the entire portfolio.
Some practical choices for diversifying:
- Stocks: Own Domestic and International Stocks; Large and Small Capitalization Companies.
- Bonds: Mix Government and High-Quality Corporate Bonds; Vary Maturity Dates.
- Industry Sectors: Limit reliance on a single industry, regardless of its popularity.
Simple principles can help avoid over-concentration:
- Do not allow any single Stock to dominate your Long-Term Portfolio.
- Do not make all-in bets on a single theme, country, or sector.
4. Maintaining Stability through Rebalancing and Expense Ratios
As time passes, markets alter the composition of the mix. If stocks rise, the portfolio has become more risky. By rebalancing the portfolio, the desired level of risk is restored.
Basic methods for rebalancing:
- Rebalance annually or biennially based upon a calendar schedule.
- Rebalance when a given asset class deviates by 5-10% from its target allocation (threshold-based).
- Expense Ratios and Fund Fees: They erode your return annually.
- Trading Expenses and Taxes: Both can negatively affect your return.
High-Cost Products that Provide Unnecessary Complexity:
- When the plan is simple enough to adhere to during turbulent markets, stability is enhanced.
Summary
Creating a well-balanced investment mix is centered around matching the assets allocated to your portfolio with the length of your time horizon, your risk tolerance and your actual cash needs. A sustainable portfolio employs core building blocks — stocks for growth, bonds for stability, and cash for flexibility — and then diversifies within each building block. Rebalancing ensures that the portfolio’s risk remains constant and that costs do not diminish returns on an annual basis. The most successful long-term investors consistently implement their plans: they maintain a clearly defined mix, rebalance with discipline, and permit time and diversification to manage the bulk of the work.