Diversifying Portfolio Allocations:
A Key Risk Management Strategy

Diversifying portfolio allocations is a lot like stepping up to the plate in baseball. If you try and hit a home run off of every pitch, your batting average (rate of return) will most likely suffer.

Diversifying portfolio allocations in your 401(k) type plans, IRAs, Health Savings Accounts and other retirement savings vehicles is a lot like stepping up to the plate in baseball. If you try and hit a home run every time up, chances are you're going to strike out more than if you tried to “hit for average.”

If you invest in just a few securities, you could hit a home run, but if you strike out you could lose most if not all of your money. If you can't afford to lose all your money, better to ease up a bit by hitting for that single, double, or triple instead.

By spreading your risk around to different areas of the “Park” (small cap, large cap, domestic, international, short and long-term, growth and dividend), your investment plan (as well as your batting average) will perform much better in the long run.

Diversifying the stock side

When diversifying portfolio allocations on the stock side, ideally you want to invest in large, medium, and small companies. Small companies are riskier but can yield higher returns over time. Larger companies are generally less volatile than medium and small companies but may have a smaller upside.

Load up around 50-50 on value and growth-oriented stocks. Value stocks include companies that are considered “undervalued” in the marketplace and pay dividends, while growth stocks pay little or no dividends but have greater growth potential. History has shown having both yields a higher return over the long term. Be sure to include those rare “blue chip” stocks as well, where both growth and generous dividends are expected.

Diversifying portfolio allocations to an even greater extent can be accomplished by investing internationally. Many great companies exist all over the world. Just remember investing internationally exposes you to double jeopardy. Not only are you betting on the performance of that foreign company, but also on how your country’s currency does versus the country’s currency in which you’re investing.

For example, a US resident investing in a Swiss pharmaceutical company does so with Swiss francs. During their holding period, return has as much to do with the performance of the company as with the exchange rate of the dollar and franc, as francs are returned to dollars when the stock is sold. International stocks sold on domestic exchanges are also affected by this same currency risk.

International and small cap stocks represent the riskier parts of a portfolio. The lower your risk tolerance and shorter your time horizon for investment, the less risky the portfolio should be.

Diversifying the bond side

Diversifying portfolio allocations is equally important on the bond side of things. Just as smaller companies offer greater risk on the stock side, it’s the same with bonds.

When you buy a bond, either individually or through a mutual fund in your 401(k), you’re in effect loaning money to that financial entity issuing the bond. The ability of that entity to pay the interest payments as promised through to maturity (as well as returning the principal) is known as bond business risk.

Just as with stocks, the higher the business risk the higher the potential return. Smaller corporations and municipalities have higher default rates than bigger entities, thus are forced to offer higher interest rates in return for that higher risk.

There are also varying degrees of bond interest rate risk in the marketplace. Interest rate risk is the chance of interest rates moving higher after you’ve locked in your rate of return with your bond purchase.

The longer the maturity period the greater your interest rate risk. For example, say you bought a 30 year bond yielding 2.5 percent, and interest rates subsequently doubled. That means new 30 year bonds are being issued at 5% with the same risk level as your bond, which means your bond is now worth less.

As you would expect, a bond purchased with a shorter maturity period, say six months, is less affected by the doubling of interest rates, as the holder endures a below-market rate of return for a much shorter time period (6 months vs. 30 years).

Diversifying portfolio allocations on the bond side can be accomplished by purchasing short, intermediate and long term bonds, as well as adding bonds with varying degrees of business risk.

Incorporating Alternative Investments

Stocks and bonds, the most commonly offered asset classes in employer-sponsored plans, are sufficient for most when diversifying portfolio allocations. Stocks represent the more volatile and riskier side, while bonds, being non-equity, fixed income type investments, the less volatile more conservative end.

Be aware there are different degrees of risk in both of these asset classes. A 30 year junk bond has way more risk than a 6 month Treasury bill, and a mutual fund investing in international markets has way more risk than an S&P 500 index fund. How risky your diversification is on both sides depends on your time horizon for investment and risk tolerance.

If you want to add even more diversity, you can invest in real estate, commodities, and derivatives. Be sure and add them to the stock or riskier side of your dynamic stock to bond ratio, as these types of investments are generally more volatile than the stock market. Be warned that investing in REITs, limited partnerships, pork bellies, cattle futures, precious metals like gold and silver, or betting on a stock market index or individual stock losing value increases your retirement plan's volatility (risk) even more.

Many 401(k) type plans offer an "open brokerage window" that make investing in these alternative investments possible. Self directed Roth IRAs offer similar opportunities.

Risk tolerance: The other piece of the pie

Along with your time horizon for investment, risk tolerance is the

The other piece of the pie is how comfortable you are with risk: i.e. risk tolerance. Don’t choose too risky a portfolio if you’re a conservative investor – you won’t sleep well at night. Pick an allocation with a risk level you can live with during good times and bad.

That’s a big part of coming up with an investment plan for your financial goals: Choosing the correct risk level. Your risk level, both now and in the future, should be an important consideration when diversifying portfolio allocations as well as determining your dynamic stock to bond ratio.

You probably already have a pretty good idea of your level of risk tolerance. If you need some guidance, try calcxml.com. Their quick, easy on-line survey instantly scores you in one of eight risk categories ranging from very defensive to very aggressive.

Remember, even a very aggressive investor has to move to a more conservative portfolio as their time horizon for investment shrinks.

Diversifying portfolio allocations and Your Retirement Plan

Diversifying portfolio allocations should be possible with most tax advantaged accounts, including 401(k) type plans. Don't be too concerned about each retirement account being diversified individually if you have more than one (like I suggest). Remember, if they are all going to be used for the same purpose (retirement), having just one investment plan to manage makes things easier.

That means it's OK if one account, when looked at alone, doesn't meet your diversification model, but when looked at along with your other accounts for retirement it's perfect. This requires some method of aggregating your account holdings, like a spreadsheet, software program, or ledger, but it's worth it. That way if your employer's offerings fall short in an area of your diversification, you can compensate for it in another account.

Try and stick with low cost index mutual funds if your employer offers them. Chances are you’ll have at least several among your choices. Of course, that depends on what options your employer chose for your 401k type plan. Be sure you know what type of securities each mutual fund is investing in and don’t pick two that invest in the same thing. That will decrease your diversification rather than increasing it.