How to Use Diversification to Allocate Your Online Investments - dummies

How to Use Diversification to Allocate Your Online Investments

By Matt Krantz

Asset allocations let all the investments in your online portfolio blend together into a stew that will be most likely to generate the highest possible return for the lowest amount of risk. The advantages of creating and sticking with an asset allocation include the following

  • Diversification: An asset allocation calls for certain percentages of your portfolio to be in certain investments. For instance, you might put 70 percent in stocks and 30 percent in bonds.

  • Rebalancing: Periodically, one group of investments in your asset allocation will fall in value. Stocks might fall and bonds rally, for instance. When that happens, the percentage of your portfolio in stocks will fall below your plan and the percentage in bonds will rise.

  • Discipline: Because trading online is so inexpensive and easy, it’s tempting to chase after popular stocks that are in the news or new investments other investors are talking about. Many of those investments end up disappointing investors because they’re overvalued.

If you were to design the perfect portfolio, you’d certainly want the maximum returns for the least amount of risk. The way you do this is by diversifying.

Diversification isn’t just the result of owning many stocks. You can reduce your risk further by combining different types of assets that zig when the others zag. Stocks that move differently than each other are said to have little correlation with each other. Investors build asset allocations by piecing together investments from popular asset classes such as the following:

  • Cash is typically parked in funds that buy short-term IOUs, such as money market funds. Money market funds are discussed in Chapter 10.

  • Bonds are generally longer-term IOUs issued by governments and companies.

  • U.S. stocks are the shares of the thousands of companies that trade on U.S. stock markets.

  • Foreign stocks are shares in companies that trade on exchanges in other countries. Foreign investing is covered at more length in a bonus chapter on international and emerging markets at the companion Web site for this book.

  • Emerging market stocks own pieces of companies in up-and-coming economies. The risk is very high, but the returns can be high, too.

  • Real-estate investment trusts (REITs) own commercial property such as strip malls, apartment buildings, or offices. They tend to have low correlation with other asset classes, making them attractive in many asset allocations. REITs also tend to pay dividends that are higher than companies in other industries.

Smart asset allocations put the asset classes together in optimal ways. For instance, foreign stocks and U.S. stocks don’t move in lockstep with each other, so they work together well in a portfolio. Bonds and stocks also move differently. Blending the right doses of these different investments together helps give you the perfect portfolio and is the very purpose of diversification.

The secret to creating a portfolio is a balancing act among three factors: expected returns, risk, and correlation. Most investors appreciate the importance of choosing investments with high returns and low risk. There’s another aspect of investing, though, you might not think about.

You want assets that don’t move in lock step with each other. The idea is this: If you own two investments, and if one is doing poorly at the time, it’s nice if the other investment is doing better. That way the investment that is doing well offsets the lagging investment. The result is a portfolio that’s a little more stable, giving you the best return and lowest risk possible.