A balanced investment portfolio is one that does not leave you overexposed to any one or two particular risks. If you invest too heavily in one security, or in any one sector, industry or region, you run the risk that events over which you have no control will have a devastating effect on your financial security. To guard against that, strive to have exposure to many different kinds of companies and securities, all over the world. In the long run, you may be able to smooth out the effects of some market declines, while still enjoying the long-term returns of these asset classes.
Diversify among asset classes. Don't keep all your money in stocks, because an economic slowdown can take a huge chunk out of an all-stock portfolio. Don't invest all in bonds, either. If interest rates rise, that event will hurt your whole portfolio, instead of just part of it. Instead, try to keep your assets spread between stocks, bonds, real estate, cash and cash equivalents, annuities, life insurance, precious metals and, in some circumstances, commodities. You can also own your own home or small business, in addition to your investment portfolio.
Diversify around the world. The United States is not the only well-regulated stock or bond market in the world. You can benefit from diversifying into other regions and countries, as well as into other currencies. If the U.S. dollar continues to fall against other currencies, exposure to investments abroad, denominated in foreign currencies, will help to mitigate the risk.
Diversify across many industries. In the late 1990s, many investors were overexposed to technology and Internet stocks, and were devastated when that bubble collapsed. Again, in the late 2000s, many investors put too many proverbial eggs into the real-estate industry, and were again destroyed when that bubble collapsed. Keep holdings in as many different industries as possible. Further, seek to limit holdings in the same industry in which you work. This prevents the same economic event from harming your portfolio and your livelihood at the same time.
Diversify between large and small companies. Large companies tend to hold up comparatively well when the stock market declines, thanks, in part, to their access to credit, cash reserves and, where applicable, dividend paying history. Small-cap stocks tend to fall more in bear markets, but they can rise very fast in bull-markets, outshining their larger brethren. If all your holdings are in the S&P; 500, you may gain diversification from purchasing shares in small or micro-cap stocks.
Rebalance periodically. Even if you start with a balanced portfolio, a substantial run-up in the prices in one asset class can leave you overexposed to a specific risk. Look at your portfolio occasionally, and consider whether you will be better off selling some of your recent winners and reinvesting the proceeds in asset classes that have not yet had a run-up.
- "The Intelligent Asset Allocator"; William Bernstein; 2000
- InvestmentU; Small Cap Stocks; Louis Baseness; December 2008
- Schwab; How to Diversify Your Investments; Bryan Olson; October 2007
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