Smart DirectionsEmmet O’Neal LibraryMountain Brook, AL

Diversification in Investing

Disclaimer• Andreas Rauterkus is not a registered

investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Andreas Rauterkus does not purport to tell or suggest which investment securities attendants should buy or sell for themselves. You should always conduct your own research and due diligence and obtain professional advice before making any investment decision.

Objectives

• What is diversification?

• The key is asset allocation

• Match appropriate asset allocation to specific financial goal

The Principle of Diversification• combining imperfectly related assets can produce

a portfolio with less variability than the typical individual asset

• the portion of risk that can be eliminated by diversification is called diversifiable risk

• the portion of risk that cannot be eliminated by diversification is called undiversifiable risk

Diversification and Portfolio Risk • Diversification and Unsystematic (idiosyncratic) Risk

– unsystematic risk can be eliminated by diversification– unsystematic risk = diversifiable risk

• Diversification and Systematic Risk– systematic risk cannot be eliminated by diversification– systematic risk = undiversifiable risk (market risk)

• Total risk = systematic risk + unsystematic risk = undiversifiable risk + diversifiable

risk

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Diversification From Combining Investments

Portfolio

No Diversification

Portfolio

Complete Diversification

Portfolio

Some Diversification

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What Is Asset Allocation?• Process of diversifying portfolio investments among

several investment categories to reduce investment risk

• Example: 50% stock, 30% bonds, 20% cash assets (e.g., Treasury bills)

• Objective: lower investment risk by reducing portfolio volatility

• Loss in one investment may be offset by gains in another

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Determinants of Portfolio Performance

Asset Allocation

91.5%

Other2.1%

Market Timing1.8%

Security Selection

4.6%

Source: “Determinants of Portfolio Performance II, An Update” by Gary Brinston, Brian D. Singer and Gilbert L. Beebower, Financial Analysts Journal May-June 1991

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The Importance of Asset Allocation• Asset allocation is the MOST important decision an

investor makes (i.e. different asset classes, NOT Coke versus Pepsi)

• Asset allocation determines about 90% of the return variation between portfolios

• This study has been repeated numerous times by different researchers, with similar results.

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Why Use Asset Allocation? • Scenario #1: $100,000 invested at 8% over 25 years

grows to $684,848

• Scenario #2: $100,000 divided equally among 5 investments (One loses principal and other 4 earn 0%, 5%, 10%, and 15% average annual returns).

• Diversified portfolio will grow to $962,800 over the long term

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Factors To Consider• Investment objective (e.g., retirement)• Time horizon for a goal (e.g., life expectancy for

retirement)• Amount of money you have to invest• Your risk tolerance and experience• Your age and net worth

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Downside of Asset Allocation• A diversified portfolio MAY generate a lower rate of

return when compared to a single “hot” asset class BUT

• You never know the “hot” asset class in advance

• Asset allocation attempts to reduce volatility and provide a competitive rate of return

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Major Asset Classes• Large company growth stocks• Large company value stocks• Small company growth stocks• Small company value stocks• Mid cap growth stocks• Mid cap value stocks

• Foreign stocks– Developed – Emerging

• Bonds– Domestic– International

• Real estate (e.g., REITs)• Cash assets (e.g., CDs, Treasury bills)

Pyramid of Investment Risk

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The Asset Allocation Process• Define goals and time horizon• Assess your risk tolerance• Identify asset mix of current portfolio• Create target portfolio (asset model)• Specific investment selection• Review and rebalance portfolio

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Other Things to Know About Asset Allocation

• Portfolio risk decreases as the # of asset classes increases

• Best results are achieved over time

• Diversify holdings within each asset category– Stock: different industry sectors– Bonds: different types and maturities

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More Asset Allocation Tips• Stick to your asset allocation model unless personal

circumstances change

• Rebalance when asset percentages change by a certain amount (e.g., 2%)

• Any one sector no > 10%- 30%