One of the basic tools of diversifying among investments is to use a percentage-based allocation model. For instance, if an investor has a $2 million portfolio, and he allocates 5 percent to cash, 60 percent to stocks and 35 percent to bonds, he would have $1.2 million in stock, $700,000 in bonds and $100,000 in cash. While the math is relatively simple, choosing which percentage to use can be a bit more complicated.
A percentage-based investment diversification model may consist of four broad classes of investments. Stocks and mutual funds that own stock make up one part of a diversified portfolio. Another part can be invested in bonds or bond funds. Many investors choose to hold some of their portfolio in cash or cash-equivalent securities. Finally, some models include alternative investments, such as commodities, precious metals, real estate or other instruments that aren't stocks, bonds or cash.
Allocation models come in a few different types. Some are tied to the strength of the market and allocate relatively more money to stocks and less to bonds while the stock market is doing well and shift money out of stocks and into bonds or cash when stocks are doing poorly. Another allocation model is to change percentages based on age. For instance, at age 60 an investor might choose to put 60 percent of her money in stock, 35 percent in bonds and 5 percent in cash. At age 80, the same investor might reduce her risk by putting 20 percent in stock, 50 percent in bonds and 30 percent in cash and cash equivalents.
Having a percentage-based diversification model requires some work. Over time, as investments grow at different rates, the portfolio can need rebalancing. For instance, a portfolio with $500,000 split equally between stocks and bonds might not always stay that way. If the stock market has two good years, the stock portion could grow by 30 percent, while the bond investments grow by 10 percent. This means the portfolio would have $325,000 in stock and $275,000 in bonds, for a 54.2 percent stock allocation and 45.8 percent bond allocation. To rebalance the portfolio, the investor would have to sell $25,000 worth of stock and buy $25,000 worth of bonds to have $300,000 in each and maintain the 50/50 split.
Percentages only tell part of the story of a plan for diversifying investments. Two portfolios with equal breakdowns could perform completely differently because the investments that make up each of their pools are as important as the way they are broken down. With this in mind, while building an appropriate diversification plan is part of investment planning, it doesn't necessarily eliminate the need to choose good investments within each general class.
Video of the Day
- Creatas/Creatas/Getty Images