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| Diversifying through Asset Mixes |
| Under Modern Portfolio Theory, the critical first step to developing a suitable investment portfolio is deciding which asset classes you want to buy, and not which individual stocks and bonds. |
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| An asset class is a group of securities that share common characteristics and respond in a similar fashion to market changes and fluctuations. The three main asset classes are stocks, bonds, and cash. Generally, adding stocks to your portfolio increases your risk and adding bonds or cash lowers it. |
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| Investing in many different asset classes makes more sense than worrying about whether a particular security is in itself "safe enough." Even the riskiest securities, such as junk bonds and derivatives, can add value to a low-risk portfolio if they are used in the proper proportion. The impact of a security on the total portfolio should be your main concern. |
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| So if you want to get a higher return for the same risk, or reduce your level of risk for the same expected return—in other words, make your portfolio more efficient—you would be smart to consider investing in the full spectrum of asset classes (within each of the three main asset classes you can choose among several different flavors of investments). |
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| Within stocks, for example, you can have large-growth, large-value, small-growth, or small-value investments. And if you want to improve the efficiency of an all-bond portfolio, you can either reduce risk or increase potential return. You could try to achieve this goal by adding bonds with varying maturity dates and interest rates to your portfolio (analogous to style and sector diversification), but it's far more likely that you'll get what you want by taking on some stocks and cash instruments (asset class diversification). |
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| The important thing to know about asset allocation is that asset classes work together to produce a desirable portfolio. Each asset class will add something. Trying to build a diversified portfolio with only one type of asset is like trying to get healthy by eating just one food group. |
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