By Julio Perez, Fall 2017 Graduate Research Assistant
“Portfolio” is another one of those investment terms most people hear tossed around but might not be sure exactly what it means. In short, your portfolio is your combined holdings of stock, bond, commodity, real estate, cash, and all other investments you might have. Usually you or your broker will have this list of all your investments, and it is an easy way for you to keep track of your interests. Once you have your portfolio, you can focus on diversifying it.
Diversification is the process of mitigating your investment risk by spreading out your investments across different stocks, bonds, real estate and other investments, a process also known as “asset allocation.” The mitigation factor is fairly evident: if half of my portfolio is dedicated to pork bellies and the other half to orange juice, when the pork belly market collapses, I will still be negatively affected, but not as badly as if all of my investments had been pooled in pork bellies. To put it colloquially, diversifying your portfolio is living by the old adage: “Don’t put all your eggs in one basket.”
Back when we discussed risk, I explained risk as an inverse correlation between risk and reward. One way of picking out a diverse portfolio is making sure your assets have uncorrelated performance, that is, they go up and down in value independently of each other. Another rule of thumb is to make sure you diversify between asset categories and within asset categories. Between asset categories means investing in bonds, stocks, and cash assets instead in just one of the three. Within an asset category means buying stock, bonds or cash assets in different companies, services, goods, etc. instead of all your investments being in one product or another. Another factor many people don’t consider is geography. You might have your investments spread out across bonds, stocks, and cash assets, and they may also be subdivided six different ways within each category, but if all those assets are focused in businesses or entities within one city or state, any local upheaval or natural disaster that throws that area’s market into disarray will hurt all of your finances.
Of course, while diversifying your portfolio, you still have to think about your risk tolerance and investment goals we discussed; you might want to put your investment into one type of stock because you expect the profit to be well worth the risk, or you might not mind lowering your profit margin if it means not losing everything overnight.
Translated: “You can’t invest all your money in fruit leather stocks! Don’t put all your eggs in one basket!”