Diversified portfolios include investments spread across different asset categories, such as fixed-income, equities, commodities and derivatives. Further diversification is possible within each asset category, such as growth and utility stocks within equities or bonds and preferred stocks within fixed-income. The asset mix of a portfolio depends on an investor's risk tolerance and financial objectives. For example, retirees may prefer bonds for regular income, while young professionals with a long time horizon might overweight stocks to maximize capital growth.
The simplest way to build a diversified portfolio is through mutual funds and exchange-traded funds, which provide broad diversification at a reasonable cost. ETFs are passively managed funds that trade on exchanges and track various market and industry indexes. You can build a diversified portfolio by buying U.S. stock funds and international ETFs, as well as stocks and bonds. Options and futures allow cost-effective ways to speculate on the direction of prices of certain assets without directly investing in these assets.
Diversification protects a portfolio by spreading business and market risk among several asset categories. Geographic diversification can take advantage of rapidly growing economies of Latin America and Asia, especially when recessions and fiscal deficits are creating market uncertainty in developed economies. Portfolio diversification across equities and fixed-income assets ensures steady cash flow and capital appreciation. Diversification within asset categories protects you from business risk. For example, if you invest in just two stocks in the equity component of your portfolio, price declines in one or both could do serious damage to your bottom line.
Diversification can be expensive. Brokers charge trading commissions, while mutual fund companies charge management fees and possibly sales commissions. ETF fees are significantly lower than that of actively managed funds, but performance depends entirely on the underlying index. Too much diversification could lead to a portfolio that neither generates sufficient income nor grows in value. There is also the risk of duplication because you may end up indirectly holding the same securities through several different mutual funds.
Rebalancing restores the target asset mix of a diversified portfolio. Changes in the valuation of different assets can affect their relative proportions, which could affect the risk profile of your portfolio and its expected returns. For example, a stock market rally could increase the equity proportion in a balanced portfolio, thus making it more volatile. You could rebalance this portfolio by investing additional funds into bonds to restore the asset mix, or you could sell some of your stocks and invest the proceeds into bonds.
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