Balancing risk and reward in your investments is critical to meeting your goals. Here’s how to do it.
Whether you’re saving for retirement or hoping to build generational wealth, knowing how and where to allocate your money is key to success. However, if you’re like many investors, you may struggle with both factors. In a 2020 survey conducted by J.D. Power, 50% of Americans said they didn’t know whether buying a single company’s stock “usually provides a better return” than investing in a mutual fund, which is naturally diversified.
While both options have their benefits, for the vast majority of investors — particularly those working toward a long-term goal — diversification is critical to long-term investment success. “Diversification is the key,” explains Brandon Thurber, Chief Market Strategist at Regions Bank. “It's a simple concept, but that's the key tenet upon which our portfolios are built.”
What is Portfolio Diversification?
In simple terms, portfolio diversification is the practice of not putting all of your eggs in one basket. A diversified portfolio is one in which your investments are spread across various asset classes with varying degrees of risk and potential for growth. Ultimately, the goal of a diversified portfolio is to balance risk vs. growth, while also helping investors withstand periods of market volatility.
In short, diversification is about reducing exposure to any single asset type, which in turn reduces the potential for volatility.
What are asset classes?
An asset class is a grouping of similar investments. The three main asset classes are:
- Equity investments (stocks)
- Fixed income investments (bonds)
- Cash equivalents (money market funds, CDs, etc.)
Because stocks represent a share in the ownership of a publicly held company, they may have high potential for appreciation — however, they often come with the greatest risk. Bonds, on the other hand, represent a loan to an entity — typically a government or a corporation. Because the bond issuer agrees to pay you back at a set interest rate on a set date, they carry a lower amount of risk and typically produce lower returns. This is why bonds are often referred to as “fixed income.”
“When you invest in a stock or bond, you're investing with the expectation of different returns and different risks,” explains Alan McKnight, Chief Investment Officer at Regions Bank.
Compared to stocks and bonds, cash equivalents are the least risky. However, because cash equivalents such as money market holdings, certificates of deposit (CDs), and savings accounts generally don’t fluctuate in price, they have limited growth potential. Nonetheless, because they can be easily converted into cash, they’re appealing options for those who would like to maintain liquidity while still earning some amount of interest.
What are alternative asset classes?
While equities, fixed income investments, and cash equivalents are three of the most popular asset classes, you may also choose to diversify your portfolio with alternative investments. Some of the most common types of alternative investments include hedge funds, real estate, commodities, and private equity. While this class of investments typically has potential for high returns, many are considered moderate-to-high risk. Also, many types of alternative investments aren’t regulated by the United States Securities and Exchange Commission (SEC).
In Episode 40 of Regions Wealth Podcast, McKnight offers a primer for those interested in learning how to invest.
How to Diversify a Portfolio
While most diversified portfolios include some combination of asset classes, the manner in which they are distributed will depend on three key factors:
- Your financial goal(s)
- Your timeframe for achieving your goal(s)
- Your risk tolerance
You probably know what your goals are and when you’d like to achieve them. Risk tolerance, though, can be harder to assess. Simply put, your risk tolerance is the amount of loss you’re willing to endure in your portfolio in exchange for potentially higher returns.
“It's important to understand the risks,” explains McKnight. “Investments can go up or down, and when there's a high risk, there’s also a potential for high reward.”
How to assess risk tolerance
While there are many online quizzes designed to help investors assess their risk tolerance, those who are working toward a significant goal may find it helpful to work with an investment advisor. In Thurber’s experience, many investors have difficulty assessing their individual risk tolerance. “You have some investors that think they can take on a lot of risk, but once you dig in, you realize they may not be as equipped to do so,” he explains.
Not only will risk appetite be unique to each individual investor, but the amount of risk you’re willing or able to bear will likely fluctuate throughout your lifetime. For example, a young investor with a long runway to retirement will likely be in a better position to withstand volatility than an individual who is nearing retirement.
“It's crucial to understand goals, aspirations, and risk tolerance for each and every client on an individual basis,” Thurber explains. “When an individual is nearing retirement, they may be entirely in bonds. Conversely, if someone is at the start of their career and taking risk is something that they're comfortable with, it's possible they may not have fixed income or bonds in their portfolio.”
Examples of Diversified Portfolios at Every Age
Early adulthood
For those just starting their career, student loan debt and low earnings are two common barriers to investing. However, with more time to benefit from compound interest, even seemingly small investments can make a significant difference long-term. With a long runway to retirement, many people in this age group are likely to have a greater risk appetite, resulting in portfolios that are more aggressive and built for long-term growth. “That translates to having a higher proportion of your portfolio in stocks rather than just in bonds or cash,” says McKnight.
Mid-career
Once many people have settled into their career, they face new variables such as home ownership, marriage, and children, meaning that most are likely to have a moderate risk appetite. As a result, a diversified portfolio for this group might balance both aggressive and conservative investments. However, McKnight notes that your actual allocation may vary based on other factors. “There may be different levers depending on if you own a business, or if you are a caregiver to elderly family members. All of those factors are critical to consider,” he explains.
Retirement
During retirement years, financial stability is key — particularly for those relying on their savings. As a result, the most common type of portfolio for this age group is low-risk and conservative. When balancing your portfolio in retirement, it may be tempting to invest more heavily in cash equivalents. However, with retirements and life expectancies longer than ever, it will be just as important to ensure you have a balanced, inflation-proof portfolio built to last as long as 20 or 30 years.
How to Diversify Your Investments
If you’re working with an investment advisor, he or she will take the time to understand your goals, assess your risk tolerance, and evaluate influencing factors before constructing your portfolio.
“It starts with the foundational element of knowledge and understanding of a client’s assets and the liabilities in order to ensure it's a holistic plan,” explains McKnight. “The advisor should then better understand what the goals of the client would be and how much risk they can take on to meet their goals.”
If you’re not quite ready to work with a wealth advisor or investment advisor, mutual funds and exchange traded funds (ETFs) are two popular ways to diversify on your own. Both ETFs and mutual funds give individual investors access to professionally managed collections of assets that include equities (stocks), bonds, and other types of securities. These funds range from conservative to aggressive, making them an appealing option for individual investors.
For new investors, investing in ETFs or mutual funds through a digital trading platform can be a great starting point. A select handful of online trading platforms provide advisor-assisted digital trading. This offers the best of both worlds: the flexibility of a digital trading platform with the support of a human advisor.
In Episode 17 of Regions Wealth Podcast, McKnight discusses the differences between self-directed trading and working with an investment advisor.
However, for those with a clear goal in mind, building a relationship with an advisor can help ensure you’re on track to achieve it. “If you are looking to ensure that you will meet your goals over that time period, and by having an advisor, you can develop a comprehensive plan that meets those needs,” says McKnight.
Ultimately, the best investment strategy will be one that’s built to suit your unique needs, goals, and aspirations. Connect with a Wealth Advisor to learn more about your options.
For more tips on building and maintaining wealth, be sure to check out Regions Wealth Podcast.
