Free Wealth Management Guide Building An Effectively Diversified Investment Por | Page 2
other words, the higher the standard deviation, the higher
the volatility and hence, the greater the risk.
enables investors to potentially reduce the overall risk in their
portfolios and increase their long-term potential returns.
Asset Allocation
Asset classes are the building blocks of an investment
portfolio. Asset classes include small and large cap stocks,
value and growth stocks, domestic and international
stocks, emerging market stocks, real estate, government
bonds and corporate bonds. Asset allocation is the division of a portfolio’s investments among asset classes to
balance expected risk and expected reward.
The Asset Class Performance Chart below illustrates how
all asset classes go through up and down cycles. Each
column contains colored boxes representing nine different
asset classes plus the CPI (Consumer Price Index), a measure of inflation. The top performing asset class each year
is ranked at the top of the chart and the worst performing
asset class is at the bottom.
Effective Diversification
Everyone has heard the saying “Don’t put all of your eggs
in one basket”. Not everyone, however, understands the
difference between effective and ineffective diversification.
Effective diversification combines multiple asset classes that
have low correlation with each other. Effective diversification
As you can see, there is random movement of each asset
class. The best performing asset class in one year is often
the worst or close to the worst performing asset class the
next year. Many investors tend to pick their investments
based upon the recent performance of that investment.
This is another reason many investors are frustrated with
the results they achieve.
The Need for Diversification
Asset Class Index Performance 1998-2012
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Annualized
Returns
Large
Growth
Emerging
Markets
REITs
Small
Value
5 Year
Gov't
Small
Value
REITs
Emerging
Markets
REITs
Emerging
Markets
5 Year
Gov't
Emerging
Markets
Small
Value
5 Year
Gov't
Large
Value
Emerging
Markets
36.65%
66.49%
26.37%
40.59%
12.95%
74.48%
31.58%
34.00%
35.06%
39.42%
13.11%
78.51%
34.59%
9.46%
28.03%
8.96%
S&P 500
Index
Small
Growth
5 Ye