Monday, June 6, 2011

Get equities in your equation – putting diversification to work

Stock markets around the world have been very volatile in the last few years. If your portfolio has lost some of its lustre because of this, you may be seeking ways of protecting yourself from investment losses by moving more of your money into ‘safer’ investments. It can be appealing to look for the stability of fixed-income investments like bonds, mortgages, T-bills, Guaranteed Income Certificates (GICs), or mutual funds investing in those types of securities. But seeking less volatility by loading up on fixed-income investments could cause damage to your financial future. This type of conservative investment usually offers a low rate of return, and potential for a drop in value when rates go up. Combining this with the eroding effects of inflation can virtually eliminate any longer-term benefits.

Market experts agree, and decades of investment experience has proven, that a diversified investment portfolio through effective asset allocation is the best way for investors to achieve the long term goals of their overall financial plan – and equities (including equity mutual funds) play a key role in achieving the highest returns for a given level of risk. Here’s how (and why) an appropriately diversified investment portfolio can help buffer market turbulence:
  • Asset classes tend to move in different directions. By loading your portfolio with a single asset class, you concentrate your risk and limit your sources of returns. A well-designed, adequately diversified portfolio encompasses all asset classes which can offset the downward movement of one class with the upward movement of another.
  • Nobody knows in advance which asset classes will outperform or underperform, and when. Because asset performance is constantly changing and the asset allocation process is dynamic and fluid, investors are best served by covering all the bases at any given time.
  • Studies have shown that the correct asset mix offsets selection risk – making asset allocation, not individual investment selection, the major driver in investment returns. In fact, as much as 90 per cent of portfolio variability can be attributed to the choice of asset types, with only 10 per cent coming from the choice of individual investments.
  • Since 1950, fixed income investments have generally reduced investment risk but have also lowered long-term growth. Over the same period, Canadian equities have produced the necessary asset growth to achieve long-term investment objectives1. The takeaway: Even conservative investors should allocate at least 25 per cent of their long-term investment portfolio to equities (including higher yielding equity mutual funds).
  • The amount of risk in your portfolio depends on your personal tolerance for risk and your time horizon. For example, if you’re close to retirement, you might want to reduce risk to protect a portion of your investments from inevitable periods of market volatility.
Diversification works. And knowing the basics can help you understand and take advantage of the risk that may be in your portfolio. The best way to play it safe? Get the asset allocation help you need from your professional advisor.
1S&P TSX Composite vs DEX Long Term Efficient Frontiers (1950-2010)

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