Managing risk is one of the most important jobs you have when you are investing. The key way to do this is to spread your risk among different investments. By putting your eggs in different baskets, you are “balancing your portfolio” and spreading your overall risk.
As you know, markets go up and down. But these ups and downs are uneven and unpredictable. When one part of the market goes up, others can go down. When stocks go ups, bonds often go down. Even on the same news, the impact can be different.
This volatility can be managed to some degree. Events like drops in commodity prices, bad management decisions, product recalls, and changes in regulations hit individual companies, industries and countries differently. These are called non-systemic risks, and these risks are what you try to manage though balance.
The tool that is used to balance non-systemic risk is diversification. By diversifying your portfolio, you can manage some of your risk. You can do this in three ways: diversifying by asset class, geography or industry.
Most of the heavy lifting of diversification happens by diversifying by asset class. When you invest, you can buy stocks, bonds and funds, or just hold cash. Each of these asset classes behaves in its own way. Stocks tend to be more volatile and risky. Bonds tend to be much less volatile and more stable. Stocks and bonds also tend to move in opposite cycles. And cash keeps its value even in market downturns.
So by spreading your portfolio among these asset classes, your portfolio can be somewhat insulated from different types of market forces. Something that hits stocks hard may be a benefit to bonds and something that hurts bonds can sometimes help stocks. So by mixing your asset holdings, your portfolio can weather many kinds of market storms.
You can also diversify your portfolio geographically. If your portfolio holds lots of US stocks, it would be a good idea to diversify by buying European or Asian investments. By spreading your money this way, a downturn in the US will only impact part of your portfolio.
Finally, you can diversify by industry. Different industries run in different cycles. A downturn in oil prices for example may be devastating to oil companies, but lower fuel prices are a boon to transportation. By buying into different industries you will make sure that a down-cycle in one part of your portfolio will not spread to your whole portfolio. If you start with broad categories such as primary industries, manufacturers and services, you can branch out into more specific categories once you get the hang of it.
Also note that Exchange Traded Funds (ETF), can be an simple, low cost way to instantly diversify your portfolio. You can find ETFs that are diversified by geography, industry or asset class. A single fund can do a ton of diversification work for you, especially when you are just starting out.
Now that you know how to balance your portfolio, we need to look at the most important part of balance: you! No matter how you balance your portfolio, you need to take into account your own risk tolerance. If you don’t have much of an appetite for risk, or really cannot afford to lose money, then your portfolio should be balanced towards more conservative products.
The most effective way to manage risk is through asset allocation, specifically the proportion of stock, bonds and cash you hold. If you have a conservative risk profile, it would be good to hold more bonds and cash and a lower proportion of stock. If you can accommodate a lot of risk, you can hold a greater proportion of stock.
As a guideline, this is a sample of what a balanced portfolio should look like: A conservative investor can have a mix of 70% bonds, 20% stocks and 10% cash. For an aggressive investor, the holdings are inverse, 70% stocks, 20% bonds and 10% cash.
If you don’t have an appetite for risk, choose a bond fund at the core of your portfolio and take only a small proportion of stock. If you have a higher tolerance for risk, maybe take a more aggressive fund as your core, and take a larger proportion of stock.
One last thing, it’s always good to go back and revisit your balance every three months. The value of your holdings will change over time, so your balance will change. Make sure you check to see if you’re comfortable with your new balance. If you’re not, rebalance by selling some of the asset where you’re overweight, putting the proceeds into the assets where you’re underweight.
So that’s balance. It’s easier than it looks. Start by diversifying between stocks, bonds, funds and cash. Use ETFs to do some easy diversification for you. Aim to diversify even further by industry or geography if you can. But make sure you’ve taken your own risk tolerance into consideration. If you do this well, even if one part of the market hits the rocks, your overall portfolio won’t be impacted severely. And that’s the goal of balance: making sure a downturn in one part of the market doesn’t ruin your whole portfolio.