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Diversification May Help to Reduce Risk

Asset Class Chart.jpgDiversifying your investments is as much common sense as it is investment science. You can diversify by investing across asset classes and by geographic regions. Asset classes include stocks, bonds, cash, real assets, and alternative investment strategies, and within those asset classes are other opportunities for diversification.

The price of stocks, bonds, and other investments don’t all move in tandem. The price of each stock is affected by a combination of different elements, including not just the company’s own performance and the health of the company’s industry but also consumer worries and the health of domestic and global economies.

Asset classes also behave differently from one another, going up and down in separate cycles or to different degrees. We believe that including a range of asset classes provides our clients with the potential for growth while minimizing the downside.

Asset Classes Perform Differently Over Time

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Equities

Let’s take a look at how equities can be diversified. Market capitalization is one way to label stocks—the total value of a company’s shares. Companies are broken down into three main categories by this measure: small cap, mid cap, and large cap. Equities can also be categorized as value or growth stocks. If a company’s stock is considered undervalued based on common metrics, it may have potential for long-term growth and be considered a value stock. Equities from companies that have a strong growth and earnings history are called growth stocks.

Another way stocks can be categorized is by market sector, such as consumer goods, services, technology, or utilities. Geography is another measure. Domestic companies are based in the U.S., while international stocks are generally considered to include companies in developed markets such as Canada, Western Europe, Japan, and Australia. A third category is companies in emerging markets such as China, Brazil, India, and Turkey.

Bonds

Bonds can also be categorized in a number of different ways. Maturity date is one measure; short term (less than four years), medium term (four to ten years), or long term (more than ten years). Ratings are another way: There are various levels of investment-grade bonds, and various levels of below-investment-grade bonds. Bonds have different yields; typically, lower-rated bonds reward investors for the additional risk by having higher yields. And the yields can be tax-exempt (most types of bonds issued by states, cities, and local jurisdictions) or taxable (Treasury and corporate bonds). As with equities, bonds can also be divided by geographical areas.

Cash

When you speak of cash as an asset class within a portfolio, you’re not talking about a pile of cash in a safe with your name on it but rather cash equivalents such as money market funds and very short-term bonds.

Real assets

Portfolio research has shown that adding real assets—such as interests in real estate, natural resources, commodities, or precious metals—can provide additional diversification that may give some protection to a portfolio because real assets may not respond to macroeconomic events in the same way that stocks and bonds do. Some people classify real assets as alternative investments, but we view them as their own asset class when they are traded on major stock exchanges.

Alternative investments

At the most basic level, an alternative investment is anything other than stocks, bonds, or cash. It’s a broad term encompassing hedge funds, private equity, long-short strategies, real estate partnerships, structured products (like collateralized debt obligations and derivatives), venture capital, and other nontraditional investments. Until the last several years, investments like these were available only to large institutional investors because minimums were very high, net-worth requirements were very high, and lock-up periods could last for years. However, now some of these strategies are available through mutual funds or exchange-traded funds. These are called “liquid” alternatives because they can be bought or sold at any time.

For some clients, we think that alternative strategies of various types can provide valuable diversification.

A word about risk

Risk, or the variability of returns, is typically reduced in portfolios that invest across a range of asset classes and strategies. Because different markets, countries, sectors, and strategies typically react to events in somewhat different ways, a well-diversified portfolio is likely to include some elements that do very well in an up market while also including other elements that may do less well in an up market but provide better performance in a down market. Although we believe in diversification in all market conditions, we set ranges for the allocations to various asset classes in most client portfolios and increase or decrease those allocations in accordance with our near-term and long-term market views.

The goal is to achieve strong returns across a market cycle while smoothing out the highs and lows. We think this is the smart way to invest for the long term.

If you’d like to discuss whether greater diversification might help your portfolio, please call or e-mail us today at (925) 365-1533 or lifeplan@accretivewealth.com.

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