The goal is to construct a diversified portfolio with a mix of asset classes that have varying degrees of correlation to one another. By holding a variety of investments that don’t all move in perfect lockstep, the overall portfolio volatility and risk can be reduced.
This involves dividing your investable assets among various asset classes, such as:
provides capital appreciation and growth, but also carry higher risk.
provides fixed income and portfolio stabilization but generally offer lower returns than stocks. Beyond traditional bonds, consider other fixed income securities like treasury inflation-protected securities (TIPS), municipal bonds, and corporate bonds. TIPS, for example, provide protection against inflation, as their principal value adjusts with inflation rates. Municipal bonds offer tax advantages, as interest income is often exempt from federal and state taxes.
provides liquidity and capital preservation, offer low risk and low returns, suitable for short-term goals. Maintaining a portion of your portfolio in cash or cash equivalents like money market funds (MMFs) and certificates of deposit (CDs) can provide liquidity and stability. These assets are low-risk and can serve as a buffer during market downturns.
Real estate investments can provide steady income through rental yields and potential capital appreciation. Real Estate Investment Trusts (REITs) offer a way to invest in real estate without the need to manage properties directly. According to the National Association Of Real Estate Investment Trusts (NAREIT), REITs have historically provided competitive returns and diversification benefits.
Investing in commodities like gold, silver, oil, and agricultural products can hedge against inflation and provide diversification. Commodities often have a low correlation with stocks and bonds, which can help stabilize your portfolio during market volatility. The Commodity Futures Trading Commission (CFTC) regulates commodity markets in the U.S.
These include private equity, hedge funds, and venture capital. These investments can offer high returns but come with higher risk and lower liquidity. They are typically suitable for investors who can absorb the illiquidity, qualify under accredited-investor or qualified-purchaser rules, and have a longer investment horizon. The Securities And Exchange Commission (SEC) oversees these types of investments.
such as Bitcoin and Ethereum trades on decentralized blockchains with volatility several multiples that of equities. Do not lean on it as a diversifier: under systemic stress and algorithmic de-risking, crypto correlations with high-beta tech converge toward — exactly when you would want the hedge, you do not have one. Treat it as an unhedged, liquidity-sensitive speculative position, sized small enough that a 70% drawdown is survivable, not as a stand-in for bonds or gold.
Within each of those broad categories, there are additional asset subclasses and geographic regions to consider as well for further diversification. Diversify systematically: allocate capital within asset classes (preferring index funds to individual stocks or bonds), and across asset classes (preferring a mix of stocks, bonds, and REITs), because you cannot predict which assets will outperform in any given cycle. You cannot control the market. A core set of funds from which to build a portfolio includes:
Always remember: past performance is no guarantee of future results.
A single optimal asset allocation does not exist for all investors. The appropriate mix depends on your specific financial situation, investment time horizon, cash flow needs, and psychological ability to withstand potential losses during market downturns. Evaluating your risk tolerance requires analyzing your psychological capacity to endure drawdowns alongside your financial capacity to absorb capital losses. Some individuals accept high volatility for the potential of higher returns, while others prioritize capital preservation. Understanding your risk tolerance is vital for making informed investment decisions that suit your comfort level.
The most influential factor in determining the behavior of your portfolio is the allocation between stocks and bonds. A higher percentage of bonds in your portfolio will result in lower volatility, but this also means lower returns. However, if you have already achieved your desired level of capital accumulation, lower volatility may be preferable as you will be taking distributions from your portfolio.
You choose the target percentages for each asset, per your wealth accumulation goals, and personal preferences. For those who have more years until retirement, a common stock/bond ratio is 90/10. If you are in the middle of your career, you may consider a ratio of 80/20 or 70/30. As retirement approaches, a ratio of 60/40 is also a reasonable option. A portfolio has a risk profile which can be calculated.
Callan’s Periodic Table of Investment Returns gives insights on behavior of different asset classes over years. Drawn as a chart it is shown in Figure 11.3.
