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An Investor’s Best Friends

Any investor would do well to call on three friends during the course of his or her financial life: diversification, patience, and consis­tency. Regardless of how the markets perform, these practices should be a part of your investment philosophy.

Diversification: a key to safe investing

The saying “Don’t put all your eggs in one basket” has real value when it comes to investing. In a bear market, certain asset classes may perform better than others. The same goes for a bull market. If your assets are held mostly in one kind of investment (say, mostly in mutual funds or CDs or money market accounts), you could be hit hard by stock market losses, or alternately lose out on potential gains that other kinds of investments may be experiencing. So there is an opportunity cost as well as risk.

This is why asset allocation strategies are used in portfolio manage­ment. A financial advisor can ask you about your goals and tolerance for risk and assign percentages of your assets to different classes of in­vestments. This diversification is designed to suit your preferred invest­ment style and your objectives.

When you look at investing, the goal is to increase your initial in­vestment dollars. This increase represents a return on your initial invest­ment. When discussing returns, the most common language is called financial or portfolio performance. The financial performance of your portfolio will come mainly from asset allocation and investment selec­tion. Studies conducted by Ibbotson Associates, Inc. show that more than 95 percent of an investor’s returns come from asset allocation and investment selection.

Asset allocation is simply the percentage of a portfolio allocated to different asset classes such as stocks, bonds, and cash. Investment selec­tion is the process of selecting choices within each asset class.

While financial markets are by nature uncertain, there are ways to reduce risk. For example, investments can be spread over a variety of companies within a given industry. They can be further allocated to a range of the more conservative asset classes, such as real estate and bonds. Diversification and allocation have been shown to reduce the probability and magnitude of investment losses. A portfolio should always be built upon the prudent concepts of diversification and al­location.

Portfolio Performance (based on Ibbotson Study):

• Asset Allocation 91.5%
• Investment Selection 4.6%
• Other Factors 2.1%
• Market Timing 1.8%

Solomon wrote in Ecclesiastes 11:2, “Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth” (nasb). Divide your wealth (investment capital) into several parts and don’t risk it all in one place. Diversification is essential regard­less of your age, personality, income level, or the time frame involved. As your savings grow, your diversity should grow, too. Diversification does not guarantee safety or success, but it does reduce risk. Make different types of investments: bonds, domestic and foreign stocks, real estate. Mutual funds offer a high degree of diversification within a single fund. Even there, invest in different types of funds: small-cap, mid-cap, and large-cap funds, emerging markets, growth and income, etc.

Here is a sample* illustration:

Asset Allocation Investment Selection