Any construction requires balance. It must be designed correctly and made of the appropriate materials to provide stability and longevity. Your investments are no different. Portfolio construction requires the correct balance of assets and risk to ensure wealth creation and preservation. Building a balanced portfolio sounds straight-forward but as you learn how to invest you will realize, there are many ways to accomplish a balanced portfolio.
Most financial websites and advisors preach the need for diversification in a portfolio. Diversification reduces risk they declare. And it does. However, it is actually balance that is needed to effectively maintain returns while minimizing risks.
Diversification limits risk by spreading investments across a variety of asset classes and/or individual stocks. A diversified portfolio should contain some mix of:
This prevents overweighting in a single asset or stock, the proverbial “all your eggs in one basket” approach. Stocks drive growth while bonds provide equity downside protection.
While at any specific time a concentrated portfolio may provide greater returns, diversified portfolios outperform historically, demonstrating the difficulty of consistently picking only a few winners. Diversification comes with a cost, though.
It inherently reduces returns by combining dissimilar investment vehicles. This is the trade-off investors make in order to preserve capital in down markets and participate in up markets.
Unfortunately, too many individual investors and financial advisors believe diversification is the cure-all to risk. They may initially diversify and then neglect to adjust their portfolio as they age or their financial goals change. Or they overdiversify their returns away by investing into too many individual stocks, mutual funds or complex alternative assets they do not fully understand.
Sometimes investors may be unaware of actual correlations of seemingly different stocks or investment products. These all diminish the performance and potentially the purpose of diversification: to minimize portfolio risk while maintaining acceptable returns. That is why portfolio balance is vital.
Diversification is a part of balance. But balance is much more. Balance is conscious, active diversity, not only in order to reduce risk, but to be aware of where the risks lie in both the portfolio and the market.
This allows investors to take advantage of market dislocations, reduce unnecessary exposures as necessary, and maintain returns during different market cycles.
Popular cookie-cutter 60/40 or 50/50 stock/bond allocation strategies are not always appropriate for an individual investor or market cycle. As investors’ goals and needs adjust over time, it requires periodic reviews of the portfolio, understanding of the holdings within, and an eye on the overall market and economy. Diversification is important. But the appropriate balance is critical for investors.
Investors seeking balance must first align their portfolios with their investment goals and the required returns necessary. Next, investors must consider their investment risk profile. A balanced portfolio will be able to achieve its objectives without taking outsized risks.
To accomplish this, the investor’s risk tolerance must also be understood at the outset. For example, individual investors with high-risk tendencies should strive for increased diversity to lower their exposure. Investors then need to assess the basic risk profile within their portfolios:
If a portfolio is overweighted at either end of this basic risk spectrum, an investor should look to adjust their holdings to become more balanced. A technology-heavy growth portfolio, for instance, should adjust to include income and value stocks to provide balance to its fundamentally high risk/high reward nature.
The final step to achieve balance is the ongoing examination of the portfolio to determine its suitability. The investments should be appropriate to the various stages of an investor’s life (young single, family, retirement, etc.) and income, but also to the changing macro-economic conditions and market cycles.
A balanced portfolio for a young single person just starting their career in a bull market will be different for a retired couple in the same market. Likewise, a family preparing to send their children to college during a bear market will require a different balance than newlyweds.
Balance is not a “one-size fits all” methodology. It requires self-awareness, financial education, and diligence. This consistent review to achieve and maintain portfolio balance not only minimizes risk and preserves capital, but also helps investors detect and recognize opportunities for increased wealth creation.
Portfolio diversification is important, but it is simply an assortment of investments. A balanced portfolio is the appropriate combination of investments that provides the most effective way to manage risk while also achieving required returns. While the returns may not be as exciting as those speculating in cryptocurrencies, a balanced portfolio, actively diversified over time, will help investors realize their financial goals throughout their lives and inevitable market volatilities and cycles.