|
| Reducing Your Risk |
| The key to investment success isn't in your ability to pick the hottest stocks or in selling and buying stocks at the right time. Instead, it's your ability to avoid subjecting your portfolio to an undue level of risk. And that's a function of how skilled you are at diversifying your investment selections and building the most appropriate asset allocation for your portfolio. |
|
| But before you can determine an asset allocation and diversification strategy for your portfolio, you first have to decide on the amount of risk to assume. And that depends on a number of factors, the most significant of which is your time horizon to your investment objective. If you are investing for a long-term objective (such as retirement in 25 years), you most likely can afford to include more risk in your portfolio. In general, the more stock you have in your portfolio, the riskier it is. That's because stocks can be extremely volatile, meaning their value can rise and fall–sometimes significantly–from one day to the next, or even within a single day. However, if you are making a short-term investment (such as buying a new car in six months), you probably want to construct a less risky portfolio. |
|
| Asset Allocation |
| The way you control risk is through asset allocation. You also can reduce your risk by investing across the various asset classes (stocks, bonds, and cash). For example, you may not want to have your entire portfolio invested in stocks, but rather allocate some to Treasury bills and corporate bonds. This is called asset allocation. One of the strengths of smart asset allocation is that it allows you to invest in securities with a low correlation. This means that one investment will zig while the other zags, so that you can increase the chances that you'll always have some investment doing well. |
|
| Diversification |
| You also can control risk by diversifying within the various asset classes. For instance, if you have your entire account in one stock and its value falls, the value of your entire account will decline by exactly as much as the stock fell. If you are equally diversified across two stocks and one declines, you will only have a 50% exposure to that loss. With three stocks, your exposure goes down to 33.3%. And so on. This dramatic reduction in risk continues as you pick stocks of companies of different size, style, business sector, and country. The goal is for your portfolio to become diversified enough so its risk is more like the total market than an individual stock. That said, eventually the laws of diminished returns will kick in. In other words, you eventually will reach the point where adding another stock or investment to your portfolio doesn't offer any additional diversification benefit. |
|
| If you are having trouble determining the most appropriate investment allocations for your retirement account, you may want to consider talking to a financial or investment advisor. Morningstar Retirement Manager also can help as it is designed to construct an optimal allocation for you based on many of the factors discussed above. |
|
|
|
> Home
> Glossary > Support |
