A Balanced Portfolio
by Justin Cooper
The expectation of positive returns underpins most investment decisions, as it should, however is appropriate consideration always given to risk management when investing.
When planning to achieve an objective, regardless of the nature, most of us will give consideration to a strategy. In doing so we will probably identify the risks that we may face, our strategy will then involve eradicating or reducing these risks with a view to increasing our chances of successfully achieving the objective. Investing should involve such a strategy.
There are a number of risks that can be identified with regard to investing, the relevance of each is best determined in the context of an investors’ specific situation. Two of the most common referred to risks are “Diversification Risk” and “Timing Risk”. Whilst Books and University Courses have been written on both, here we will attempt a brief explanation.
Predicting which asset class, or which assets within a class of assets, will provide the highest return over the short term is extremely difficult, doing it over the long term even more so. By not having diversity an investor considerably increases their overall risk due to the success of their strategy becoming dependent on the performance of fewer assets, this is called “Diversification Risk”. By spreading the invested funds over a broader array of assets and/or asset classes returns over time will be smoothed as the impact of each individual asset has a lesser impact on the overall portfolio.
Buying at the bottom of the market and selling at the top is no doubt a highly recommended strategy, though given the “herd mentality” attached to financial markets, many investors find that they ultimately invest the other way around. The decisions of buying and selling are often made with the human emotions of fear and greed at play and generally many investors “shut the gate after the horse has bolted.”
By attempting to select the right time to buy and sell an investor is significantly increasing their “Timing Risk”. Predicting the right time is extremely difficult to achieve consistently over an extended period. It is the “Time in the Market” not “Timing the Market” that assists in achieving investment objectives. Timing risk can also be reduced through “Dollar Cost Averaging” which is a fancy way of describing an approach whereby funds are “drip fed” into an investment consistently over a period of time, say the same amount on the 1st of every month, this removes the emotional influences and ensures a purchase price that is the average price of an asset over a period of time rather than the given price on a given day.
An Investment Strategy that incorporates approaches to reducing these two risks probably won’t sell out to many get rich quick seminars however will aid in developing a balanced portfolio. Is your investment strategy inspired by the need for balance?