Page 61 - DMGT515_PERSONAL_FINANCIAL_PLANNING

Personal Financial Planning

Notes why it’s important to have money in multiple asset classes at all times. You can always adjust
your portfolio allocation if economic signs seem to favor one asset class over another.
Financial services companies make adjustments to the asset mix they recommend for portfolios
on a regular basis, based on their assessment of the current market environment. For example,
a firm might suggest that you increase your cash allocation by a certain percentage and reduce
your equity holdings by a similar percentage in a period of rising interest rates and increasing
international tension. Companies frequently display their recommended portfolio mix as a pie
chart, showing the percentage allocated to each asset class.
Modifying your asset allocation modestly from time to time is not the same thing as market
timing, which typically involves making frequent shifts in your portfolio holdings in anticipation
of which way the markets will turn. Because no one knows what will happen, this technique
rarely produces positive long-term results.

3.7.2 Using Diversification

When you diversify, you divide the money you’ve allocated to a particular asset class, such as
stocks, among various categories of investments that belong to that asset class. These smaller
groups are called subclasses. For example, within the stock category you might choose subclasses
based on different market capitalizations: some large companies or funds that invest in large
companies, some mid-sized companies or funds that invest in them, and some small companies
or funds that invest in them. You might also include securities issued by companies that represent
different sectors of the economy, such as technology companies, manufacturing companies,
pharmaceutical companies, and utility companies.
Similarly, if you’re buying bonds, you might choose bonds from different issuers—the federal
government, state and local governments, and corporations—as well as those with different
terms and different credit ratings.
Diversification, with its emphasis on variety, allows you to manage non-systematic risk by
tapping into the potential strength of different subclasses, which, like the larger asset classes,
tend to do better in some periods than in others. For example, there are times when the
performance of small company stock outpaces the performance of larger, more stable companies.
And there are times when small company stock falters.
Similarly, there are periods when intermediate-term bonds—Treasury notes are a good example—
provide a stronger return than short- or long-term bonds from the same issuer. Rather than trying
to determine which bonds to buy at which time, there are different strategies you can use.
For example, you can buy bonds with different terms, or maturity dates. This approach, called a
barbell strategy, involves investing roughly equivalent amounts in short-term and long-term
bonds, weighting your portfolio at either end. That way, you can limit risk by having at least a
portion of your total bond portfolio in whichever of those two subclasses is providing the
stronger return.

Alternatively, you can buy bonds with the same term but different maturity dates. Using this
strategy, called laddering, you invest roughly equivalent amounts in a series of fixed-income
securities that mature in a rolling pattern, perhaps every two years. Instead of investing a lump
sum in one note that will mature in 10 years, you can invest small sum of money in a note
maturing in two years, another smaller amount of money in a note maturing in four years, and
so on. This approach helps you manage risk in two ways:

If rates drop just before the first note matures, you’ll have to invest only small amount at the
new lower rate rather than the full bigger amount. If rates behave in traditional fashion,
they will typically go up again at some point in the ten-year span covered by your ladder.

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