The ChoosaBroker Trading Academy
No matter what you plan to invest in, whether it be stocks, bonds or commodities, don’t put all your eggs in one basket. It is hard to overstate the significance of diversification of investment portfolio. Concentrating your portfolio around one single instrument is the single biggest reason why a large number of investors fail to meet their financial goals. In this lesson, we will learn about:
Why Diversification Matters?
Components of a Diversified Portfolio
- Equities, both domestic and international, represent the most aggressive chunk of a portfolio and offer the maximum returns over the long term. However, the higher growth potential comes laden with greater risk. The equity portion of a portfolio can be further diversified in to defensive, cyclical and growth stocks, with the latter two accentuating the returns, while defensive stocks help provide cushion during market downturns.
Bonds provide regular interest income and are less volatile than stocks. Generally, bonds pay interest twice a year. If held to maturity, bondholders also get back the entire principal invested. Bonds are integral to a portfolio because of their inverse relationship with stocks. When stock prices go down, bond prices go up, and vice-versa, making bonds an ideal shield against declines in equity markets.
Money market instruments and short-term certificates of deposit are ultra conservative investment vehicles that provide stability to a portfolio and offer easy access to capital. In return for that level of safety, money market assets typically generate lower returns than both bonds and stocks. Transactions in money market instruments are wholesale, meaning they happen only in large denominations. Individual investors can instead opt for money market funds that offer the potential for higher yields than conventional cash equivalents.
Modern portfolio theory advocates that a portfolio’s performance can be improved by investing in assets that have low correlation to each other. Gold is one such instrument that moves independently of both stocks and bonds. Gold has also historically proven to be an excellent hedge against inflation, because its price tends to increase with a rise in the general price level.
Diversified Portfolio Models
20% stocks – 80% Bonds
40% Stocks – 60% Bonds
50% Stocks – 50% Bonds
70% Stocks – 20% Bonds
80% Stocks – 20% Bonds
**US equity market returns were calculated by computing the returns of the S&P 500, the S&P 90, the Dow Jones Wilshire 5000, the CRSP US Total Market Index and the MSCI US Broad Market Index during separate periods of time.
**Bond market returns in the US were measured by using the Citigroup High Grade Index, the S&P High Grade Corporate Index, the Bloomberg Barclays US Aggregate Float Adjusted Index and the Bloomberg Barclays US Aggregate Bond Index during separate time intervals.
** The index that was deemed to be the best representation of the referenced market during a particular time-period was used.