Life is full of ups and downs; and the financial markets are no different. As an investor, you’re no doubt happy to see the “ups” — but the “downs” can seem like a real downer. Isn’t there any way to help smooth out the volatility in your investment portfolio?
First of all, to cope with volatility, it’s helpful to know what causes it; and there can be many causes. Computers that make trades in milliseconds, based on mathematical models, are sometimes blamed for intraday volatility, but large price swings can also occur following the release of government economic reports, such as those dealing with unemployment and housing starts. Global events, such as the European economic malaise, can also send the financial markets into a tizzy.
By being aware of the impact of these events, you can see that the workings of the markets — especially their volatility — may not be as mysterious as you thought. Still, while knowing the causes of volatility can help you prepare for market swings, it won’t blunt their impact on your portfolio. To do that, you need to create a diversified mix of investments because your portfolio can be more susceptible to negative price movements if you only own one type of asset.
To illustrate: If you owned mostly bonds, and interest rates rose sharply, the value of your bonds would likely drop, and your portfolio could take a big hit. But if you owned stocks, bonds, government securities, certificates of deposit (CDs) and other investment vehicles, the rise in interest rates would probably affect your portfolio less significantly.
Unfortunately, many investors think that if they own a few stocks and a bond, they’re diversified. But you can actually extend your diversification through many levels — and you should. For the equity portion of your portfolio, try to own stocks representing many market sectors and industries. Also, consider international stocks. And rather than just owning U.S. Treasury bonds, consider corporate bonds and municipal bonds, and diversify your fixed-income holdings further by purchasing short-term, intermediate-term and long-term bonds. Work with your financial advisor to determine the mix of asset classes and investments that are appropriate for your financial goals and objectives.
How you ultimately diversify your portfolio depends on your risk tolerance, time horizon and long-term goals — there’s no one “correct” asset mix for everyone. And over time, your diversification needs may change. To cite one example, as you enter your retirement years, you may need to increase your percentage of income-producing investments while possibly reducing the amount of growth investments you own. These growth-oriented investments tend to be more volatile, and you may want less volatility during your retirement. However, even during retirement, you will need to own a certain percentage of growth investments to provide you with the growth potential you’ll need to stay ahead of inflation.
Keep in mind that diversification can’t guarantee a profit or protect against loss. Nonetheless, building a diversified portfolio may help take some of the volatility out of investing — so look for diversification opportunities whenever possible.