How to be Successful in Investing — Part V

The last segment of the five-part series of Kiplinger’s “The Five Keys to Investing Success” focuses on portfolio diversification.

The reason to diversify is simple: spread the risk over different sectors, different asset classes so that they won’t have the same fate at the same time, i.e., when one sector/asset class performs poorly, other may perform better to offset the loss. Of course the ideal diversification is to build a portfolio with sectors/asset classes that have zero correlation, but we all know this is impossible as different industries are increasingly interlaced. So the best we can do is to reduce the correlation among sectors/asset classes in our portfolio. Kiplinger’s article also offers some straightforward reasons for diversification:

  • As the adage goes, you shouldn’t put all your eggs in one basket.
  • No investment performs well all the time; when one thing is down, another thing tends to be up.
  • You may be able to increase your return by diversifying.

Diversification also means that you have to choose the right mix of assets in your portfolio. Playing safe by investing in, for example, Treasury bills and bonds can guarantee you the safety of your principles, but it’s not going to help you achieve your goals especially when you have time on your side. On the other hand, building an all equity portfolio can greatly increase the risk without adding any significant returns. The figure below (from Zephyr Associates) shows the relation between risk (standard deviation) and return for historical data from 1926 to 2004, using the Efficient Frontier theory.

What this plot shows is that the curve goes flat as we move to further right (more risky portfolio), which means adding risk won’t result in greater return, while moving to the left can minimize the risk by investing in Treasury bills, but the return is also the lowest. To achieve the expected return, your portfolio should be diversified and balanced between the risk and return.

Here’s an interactive tool that you can play with to find the mix of different asset classes with your age, current assets, savings per year, tax rate, required income, risk tolerance and economic outlook as inputs.

 

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