Every time we turn on the radio or television we are barraged with information on the ups and downs of various domestic stock market indexes, as if they were the only components of a well-diversified portfolio.
In actuality, diversification involves exposure to both international and domestic stocks and bonds, with varying maturities and quality, as well as a growing group of investments we call alternative, which tend to have low correlations to stocks and bonds, in an attempt to increase returns and reduce risk.
In recent years at Sampson Investment Management, we have also held varying allocations to cash, in an attempt to mitigate risk during periods of high volatility and over-valuation.
One of the very first things we do as financial advisors when we start working with a new client, is to assess his or her risk tolerance in order to come up with an asset allocation model that can assist us in deciding the range of exposure the client should have to the various asset classes we have mentioned above.
The asset allocation model then dictates how investment decisions are made moving forward, and represents the most important decision we make in determining long term returns for a portfolio. The asset allocation model attempts to match the client’s risk tolerance and age with a model that balances risk and performance in an attempt to meet the client’s financial goals and objectives while keeping risk and volatility at levels the client can tolerate.
A well-diversified portfolio is thus much more than a portfolio of domestic stocks. It involves exposure to domestic and international stocks and bonds, alternative assets, and even cash during periods of increased risk. A well-diversified portfolio is not a stagnant, unchanging mix of assets, but rather a mix based on an asset allocation model that best fits the risk tolerance of the client.
The allocation among these various asset types can vary over time as market valuations increase or decrease. In the end, a diversified portfolio, based on a client’s unique risk tolerance and life situation, can provide the best opportunity for the achievement of the client’s goals and objectives, at a risk level that allows the client to sleep at night.