You’ve heard about diversification, you know it makes sense, yet, when it comes to knowing how best to diversify investments, you’re just not sure you know how to do it. We think that one of the reasons it’s hard for individuals to properly diversify is the lack of a true understanding of your own risk budget.
You see the headlines–“Foreign stocks are much cheaper than U.S. shares, and now that growth is picking up around the globe, it’s time to start buying.” Barron’s May 15, 2017. When you see the headline, you may wonder which foreign companies you should invest in, or, what mutual funds or exchange-traded funds make sense. You may be thinking to yourself that you just lived through 3 years in a row (2013,14,15) of your emerging market fund being down. Why would you want to take on that risk again? The reality may be that you sold it in early 2016, just before it started to tick up, missing a solid double-digit return.
Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. One of the major goals of diversification is the lack of correlation of one investment to another. When one is moving down, another may be moving up. When you diversify your investments, consider the level of risk of a particular sector or asset class. For example; financials, technology, and consumer staples are sectors of the market with potentially different levels of risk. An asset class could be, for instance, a stock, bond or money market instrument, all of which have potentially different levels of risk as well. The higher your risk budget, the more you may diversify in that riskier investment, the lower your risk budget, the less you may diversify into that riskier investment.
What are some of the factors of your risk budget?
- Time Horizon – how long until you need to use the money?
- Liquidity – if this pool of money is for the long-term, do you have other resources in case of an emergency? Or, would you need to use some of the money in an emergency?
- Comfort Level with risk – how much or little does loss on your money affect you personally, emotionally? Does it become a focus of your attention and keep you up at night? Or, do you have little to no concern?
According to Morningstar, risk budgeting is the process of identifying, quantifying, and spending “risk” in the most efficient manner possible. At Lenity Financial, once resources and goals have been established, we talk with our clients about their own personal risk budget so that we may help them to diversify in the most efficient, effective and comfortable way possible.
If you have the answers to the factors of your personal risk budget, you’ll be well on your way to diversifying your money in a manner best suited for you.
Important Note: The views expressed in this post are as of the date of the posting and are subject to change based on market and other conditions. This post contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Please note that nothing in this post should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and should not be taken to be, investment, accounting, tax or legal advice. If you would like investment, accounting, tax or legal advice, you should consult with your own financial advisors, accountants or attorneys regarding your individual circumstances and needs. No advice may be rendered by Lenity Financial, Inc. unless a client service agreement is in place.