Michael McCarthy of Smith Barney discusses financial planning options for your future.
Most of us have heard the saying: “Don’t put all of your eggs in one basket.” For years, financial experts have urged investors to spread their money across different types of asset classes—such as stocks, bonds, and cash—in order to reduce risk and enhance long-term returns.
Yet, all too often investors ignore this advice, pouring the bulk of their funds into a relatively narrow handful of investments – or even into a single stock. Proper diversification is an important factor to achieving long-term financial success. This article explores some of the many factors that must be considered when constructing a properly diversified portfolio.Modern Portfolio Theory
The concept of diversification finds its roots in Modern Portfolio Theory. This theory states that portfolios created using a mix of different asset classes and investment styles deliver higher returns with less risk than any one asset would by itself. The goal of asset allocation is to identify the best possible combination of stocks or other assets, based on their expected returns and the expected fluctuation – or volatility – of those returns over time. With this knowledge in hand, investors can construct portfolios that reflect this optimal mix as closely as possible.
Portfolio PerformanceAn asset classes’ success is decided by the correlation between the rate of return and the level of risk in the portfolio. Therefore, the portfolio’s performance is dependent on the strength of the correlation. Modern Portfolio Theory predicts that the higher the risk, the higher the return. The same would hold true if the opposite were to occur; however, even asset classes with lower returns and a higher risk may improve portfolio performance. The portfolio performance is based on the strength of the relationship between risk and return.
Experienced investors expect diversified portfolios to fall above any specific asset class on a chart that plots risk and return. This is because combining assets in diversified portfolios historically has allowed investors to earn higher returns with less risk then they could by investing in any single asset class alone. The most properly diversified portfolios reflect the best trade-off between risk and return given the various possible combinations of assets.
Asset Allocation Process
Developing an asset allocation strategy requires an examination, using statistical estimates, that includes a careful analysis of both past asset class performance and expected future trends. While asset allocation begins with an analysis of historic asset performance, it doesn’t end there. The capital markets are dynamic. Therefore, what occurred yesterday may not happen tomorrow. With so many different variables and strategies impacting diversification decisions, investors may find it difficult to chart an appropriate course.
Although diversification does not guarantee a profit or protect against market loss, it’s important to consider the factors such as past performance, expected returns, volatility of an asset class, and the correlation between the two when considering your diversification strategy. Of course, past performance is no guarantee of future results.
About the author
Michael McCarthy is a financial planning specialist with Smith Barney. Smith Barney is a division of Citigroup Global Markets Inc. and its affiliates and is used and registered throughout the world. CITIGROUP and the Umbrella Device are trademarks and service marks of Citigroup or its affiliates and are used and registered throughout the world. Securities are sold through Citigroup Global Markets Inc.
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