Risk and Diversification Portfolio
Investors worry about risk all the time, without always taking into account that there are many different kinds of risk. In the end, playing it too safe can be just as dangerous as chasing high flying stocks. The key to balancing risk in your portfolio is to tailor your investments to your specific needs. Building a personal portfolio allows you to participate in the potential upside of the stock market while protecting yourself from downside risk.
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Too Aggressive
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When you are building your portfolio, you run the risk of being too aggressive, especially if you are young and just getting started with stocks. There is often a temptation to bet too much on a single stock, or diversify among only a handful of stocks. The problem with that approach is that it concentrates your risk, and if something bad happens to a company in your portfolio it could have a huge impact on your total investment. One way to reduce the risk while still investing in stocks is to purchase a widely diversified mutual fund instead. An index fund is a good choice because it holds all of the stocks in the index. Since the fund is so widely diversified, it is not as reliant on the fortunes of a single company.
Not Aggressive Enough
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While being too aggressive can be dangerous to your net worth, playing it too safe can be just as hazardous. Some investors are so worried by the movements of the market that they sit on the sidelines, investing only in CDs and other guaranteed investments. But while there is no risk of losing capital in those investments, you do risk losing significant purchasing power over time. The low rates on CDs and money market funds may not even keep pace with inflation, so you could end up with much less money than you anticipated. Using a balanced approach where you keep some money in cash for emergencies and invest the rest can help you stay ahead of inflation.
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Factors to Consider
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A portfolio that is far too risky for one investor may be perfect for another. Everyone has different needs and a different risk tolerance, and it is important to build your portfolio based on those factors. If you are getting ready to retire, having 100 percent of your portfolio in stocks would be extremely risky. But that same portfolio could be appropriate for a new worker just getting started with his career. When you develop a diverse portfolio, you need to do it based on your own needs, not on hard and fast investing rules.
Annual Rebalancing
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One of the best ways to control risk in your portfolio while ensuring that you stay on track is to review your asset allocation on an annual basis. Tax time is the perfect time to do that analysis, since you already have all the paperwork in hand. Find the sum total of all your investment assets, including retirement funds and personal accounts. Then determine what percentage is in stocks and stock mutual funds, how much is in bonds and how much is in cash. Once you know where you stand you can determine whether or not that asset allocation still makes sense. If not, you can sell some assets from one class and use them to purchase assets in another.
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References
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