A key determinant in your long-term investment performance will likely be a result of the asset mix decision. Some will tell you (e.g. brokers, financial press, business show commentators) that success can come from timing - when to get in and out of the market, picking the right stock at the right time, and/or picking the next hot manager. While that all sounds great, we are afraid it just isn’t so. In fact, it has been shown that these behaviors in many instances will actually reduce your overall rate of return.
The first step in setting up your investment strategy is to make the asset allocation decision that is right for you. This means deciding how much of your money will go into cash, bonds, stocks, and sometimes real estate.
Sadly, many individuals and advisors spend little time formulating the right strategy. As a result, they end up with a collection of holdings that is neither efficient from a tax perspective, nor properly matched to manage risk. It’s akin to building a new house without having architectural drawings done first. It might work out, but then again you might get something completely different than what you expected.
Your individual asset allocation needs to be customized to your situation, and should consider factors such as your age, time horizon, tolerance for risk, and specific short-term cash needs. When properly done, it will create a balance between the amount of risk you are willing to take and the level of return you want to achieve.
A key benefit of diversification is that it can reduce your overall volatility. This in turn can result in your portfolio value being higher at the end of the day. Your portfolio value at any future date will simply be a function of the compound return. So when the choice is between a portfolio that is making 15% one year and losing 25% in another versus the portfolio that is more consistent (or less volatile) - you will want to go for the latter. Consistent annual returns can result in a higher compound return.
Here's another way of thinking about this: if a portfolio goes down 50%, it has to make 100% to get back to even. Whereas, if a portfolio declines 7% it would only need to make 7.6% to recover the loss.
One of the most important things that we do for all of our clients is creating a customized asset allocation strategy that is consistent with their specific objectives.
Then, over time, we continue to monitor the strategy and make adjustments as needed. And when we think about why our clients have a positive investment experience – diversification “really” is the key.