Fishing is the attempt to convince a fish that what is at the end of your line is an edible and tasty morsel. The problem is different fish respond to different types of bait, so if you want to be assured of success, you have to know exactly what's biting on any given day — and what it wants to bite. Or you could try flies for trout, worms for walleye and crickets for bass as an example. The more you diversify, the better your chances of being successful.
As economic and market conditions change, different types of investments thrive and falter. Catching a winner isn't easy, but when you "fish" with three lines, i.e. a mix of equities, income investments and cash, you may achieve more consistant results than any one line alone.
Don't Let The Big One Get Away
Just as fishing with three lines increases your chances of taking home a fresh fish, holding more than one type of investment may increase your chances of having a good return. When you have a mix of different types of investments you can better weather the ups and downs of the market. That's because as the values of some types of securities decline, the value of others may increase, resulting in a “cushion” for your overall investment portfolio and providing you with a comfortable rate of return.
Testing The Water
There are three basic types of investments. Stocks are also called equities and have the greatest potential for growth with the most risk. Cash, which includes money market investments, presents the fewest opportunities for growth and is the least risky. Bonds are also called income investments, have some potential for growth. They present more risk than cash but less risk than stocks.
Trying More Than One Pond
Generally, a balanced portfolio will have a mix of all three investment types. You can also diversify by investing in other investment categories within equity and income investments.
For example, equity investments can be divided into narrower investment types, or categories: growth-style and value-style investments. Growth-style investments are stocks of companies that are expected to experience rapid earnings growth resulting from strong sales, talented management and dominant market positions. Value-style investments are shares in companies that investors deem unattractive for some reason and as such tend to be priced low relative to some measure of the companies' worth.
Equity investments are also divided by the market capitalization of a company's stock, which is the measure of the size of a publicly traded company, as determined by multiplying the company's share price by the number of shares outstanding. This is why investments are referred to as “large-cap” or “small-cap” investments.
You can further diversify his or her equity investments by spreading risk across different industries or geographical regions. Someone who invests in one type of investment (such as stocks) and one investment category (such as large-cap growth stocks) might spread risk by investing in companies in a number of different industries or companies based in different geographical regions, both domestically and internationally.
Similarly, bonds are categorized based on time-to-maturity and quality. An investor who wishes to minimize exposure to risk may invest in a bond with a relatively short maturity, such as a 3-month U.S. Treasury bill, instead of a bond with a long maturity, such as a 30-year U.S. Treasury bond. Such an investor would also want to consider bonds rated as “investment grade” by Standard & Poor's and Moody's. For more information about risks associated with bonds, please see When One Goes Up, The Other Goes Down: Rising Interest Rates Could Mean Falling Bond Values.
Getting More Bite For Your Bait
Investing in mutual funds instead of individual stocks can ease the burden of diversification, because the assets of each mutual fund are usually invested in dozens of different companies. How much to allocate among stocks, bonds and cash, as well as how much to allocate among stock and bond categories, depends on your age, your investment horizon, other demands on your dollars, your tolerance of volatility and the size of your portfolio.
Diversification takes effort. Some part of your portfolio, such as stocks, may grow faster than other parts, such as bonds. Eventually your portfolio will become unbalanced. In some cases, you may want to reallocate assets in order to retain the appropriate percentage of assets in each area, based on your investment needs.
Creating and then maintaining a diversified portfolio can be a complicated process. Your financial representative is ready to help, both with an initial asset allocation consultation and periodic portfolio checkups.
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