Maintaining a diversified portfolio – why and how?

It’s important to maintain diversification in a portfolio, especially in challenging economic times. That means keeping an appropriate balance of your investments in the stock market. If you’re invested in the market, even by a small percentage, your chances of benefiting from a recovery are greater, according to the Schwab Center for Investment Research (SCIR). In the 12 months following the end of a bear market, a fully-invested portfolio has returned an average of 47 percent, the center reports, and if the first six months of the recovery were missed because the portfolio was totally in cash, the return was only 11 percent. (1926-2002, Ibbotson Associates, using the S&P 500 as proxy for the market.)

A sound investment strategy includes a well-diversified portfolio of stocks and other securities. A common pitfall among investors is the urge to commit a disproportionate percentage of funds to an individual stock (IBM, for example, because you inherited the shares from your grandfather) or to try to cash in on certain stocks or industries that may seem hot at the moment (such as defense industry stocks during wartime). Rather than becoming married to individual stocks, investors should commit to an investment strategy that helps them to pick and choose investments and get out when appropriate.

Yet, diversification means more than simply dispersing one’s “eggs” into many baskets.  The goal is to balance risk and return within your portfolio of investments. The best way to reach that balance is through strategic asset allocation based on modern portfolio theory.

Modern portfolio theory explains the benefits of portfolio diversification and demonstrates quantitatively why and how it works to reduce risk. First documented in 1952 by Harry Markowitz, who later won a Nobel Prize in Economics for his work, the theory has become widely accepted by institutional investment managers during the past 50 years. Markowitz was also the first to establish the concept of an efficient portfolio. Simply put, if efficient is defined as more output for less input, then an efficient portfolio can be defined as more return for less risk.

So what does all this mean, exactly? Keeping in mind that it’s called modern portfolio theory and not modern portfolio absolute fact, there are ways you can apply this concept to your investment plan.

Begin by infusing as much “fact” into your plan as possible. How old are you? When do you want to retire? What lifestyle do you currently enjoy (measured by monthly expenditures)? From these facts, you can derive additional facts – such as your retirement lifestyle goal, the amount of capital required and consequently your required rate of return.

Next, begin applying theory. Markowitz suggests rate of return can be predicted based on the type (or asset class) of an investment. The risk of an investment can become an objective measure by calculating the standard deviation of its past returns. The standard deviation is a statistical calculation that will tell us the likely range of possible returns compared to the average return.  In simple terms, you might have an investment that averages 10 percent return with a standard deviation of 8 percent. In this example, most returns will range between 2 percent and 18 percent in any given year.

By analyzing expected returns and corresponding risk for each asset class, we can begin to determine if the required return for your plan is achievable. We can also determine the likelihood of meeting that return. Further, by combining multiple asset classes into your portfolio, we can further reduce your risk, while maintaining expected return. Thus, the portfolio becomes more efficient.

The planning process then becomes subjective, as we work to assess whether you can tolerate the level of risk (standard deviation, uncertainty) required to meet the expected return. Do not minimize the importance of assessing your risk tolerance. Risk assessment is the most important, and most difficult, step. Since sticking to your plan is the biggest determinant of success, it’s critical that you choose a plan that you will keep. Taking on too much risk results in anxiety, stress, sleepless nights and ultimately abandonment (and subsequently, failure) of the plan.

Again, bring as many facts into the equation as possible. How did you react to past market losses? Did you sell out, feel anxiety, experience regret? How readily can you replace your portfolio, or where are you in your wealth building cycle – creation, accumulation, preservation, depletion? And how important is your objective? Are you willing to take additional investment risk that may result in the delay of retirement five years if you don’t achieve the expected return?

After assessing risk, you must then determine if the expected return in the investments that you are considering with your corresponding risk will meet your needs. If not, it’s back to the beginning, to re-evaluate your financial needs and goals.

Staying the Course with Investing and Diversification

Once you’ve established the best plan for your needs, stick with it – but don’t neglect it. A recent Harris Polls Interactive survey found that approximately 12 percent of investors have never reviewed their investment portfolio, and about 22 percent have not reviewed their portfolio for two or more years.

Your portfolio can get out of shape over time, due to the outperformance or underperformance of various asset classes and industry sectors. Your personal circumstances also can change over time, which impacts your overall financial plan. Thus, periodic reviews of your plan and rebalancing of your investment portfolio to optimize diversification are essential to assure your long-term financial success.

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