Are all your eggs in the one basket?
Diversification, Asset Allocation & Re-Balancing Investments
East Cork Journal Article – Thursday 31st March 2016
Clearly, having all of your money in one asset is a risky strategy. You have probably heard of the well-used phrase, “Don’t put all of your eggs in one basket,”? If you have, you will then hopefully understand the idea of diversification and why it is so important for protecting your assets over time. Learn more about what this means for your finances with this Diversification, Asset Allocation & Re-Balancing Investments article.
Diversification is simply ensuring that your assets are varied and not all in the one basket or asset class. Asset and financial diversification helps reduce the risk you take in your finances and is an important part of making sure that your financial goals aren’t disrupted by the unforeseen.
Why diversify your investments?
When you start to build your portfolio, you have a number of different asset classes that you can consider, such as property, cash, equities and bonds as examples. At this point, within those various asset classes, you have even more options to choose from. For example, you could invest in European equities or US property and within the bond and fixed income sector, you could introduce a blend of corporate bonds (say, issued by Nestle, BMW etc.) or sovereign bonds (such as UK government gilts, Irish government bonds).
By diversifying and investing in more than one asset, you reduce the risk that you will deplete your funds and your portfolio’s overall investment returns should have a smoother, more consistent journey. If one asset category’s investment return is volatile, the hope is that you can offset the losses in that category with better investment returns in another asset category.
What is asset allocation?
Asset allocation is the process of dividing your assets and investments across a varied spread of assets, based on an individual’s personal situation and short, medium and longer term objectives. Ensuring that you have a suitable asset allocation strategy in-place is key to ensuring the success of your money management and financial planning.
Determining the most appropriate asset allocation model for your financial goal (for example, creating an education plan for your children, retiring early etc.) is a reasonably complicated task. Essentially, you’re trying to choose a mix of various assets that have the highest probability of meeting your goal at a level of risk you can live with. As you get closer to achieving your goal, you’ll need to be able to adjust the mix of assets to reduce the risk and preserve as much of the gain as you can.
Why asset allocation is so important?
You can protect your portfolio against significant losses by including various asset types with investment returns that move up and down under different market conditions.
Traditionally, the returns of the main asset classes (bonds, equities and property) have not moved up and down at the same time. Market conditions that cause one asset to do well, might often cause another asset category to have mediocre or poor returns.
How does rebalancing a portfolio help you?
The process of ‘rebalancing’ is the act of bringing your portfolio back to your original asset allocation mix. This is necessary because over time some of your investments may become out of alignment with your initial investment goals and you will need to re-assess the underlying asset mix.
For example, you might find that some of your investments will grow faster than others. By rebalancing, you can try to ensure that your portfolio does not exaggerate one or more asset class, and you can return your portfolio to your chosen level of risk.
I have found that I rebalance my clients’ portfolios with 3 main approaches:
- We can sell certain investments from over-weighted asset classes and use the earnings to purchase investments for under-weighted asset classes – for example, we might feel that the equity element is currently too risky and we want to purchase more fixed income assets to reduce the risk;
- We can purchase new investments for under-weighted asset categories – for example, we might feel that we are currently under-weight property, therefore we may need to purchase more property assets across the portfolio;
- Finally, if we are making continuous monthly / annual contributions to the portfolio, we can alter the client’s contributions so that more investments go to under-weighted asset categories, until the portfolio is back into balance and in-line with their risk profile and target return.
A portfolio review is a key strategic activity that should happen on a regular basis between a client and their advisor, principally because it is governed by a variety of factors like the client’s age, income requirements and risk tolerance. There is no doubt that spending the time to determine which asset allocation strategy best meets your requirements will stand to you over time.
Gerard O’Brien LL.B LL.M CFP®QFA is the Owner of Heritage Wealth, a Financial Planning practice based in Main Street, Midleton, Cork. For more information, contact Gerard at firstname.lastname@example.org www.heritagewealth.ie