Smart Directions Portfolio Diversification - 2/4/2016

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Dollars and Sense

Smart DirectionsEmmet ONeal LibraryMountain Brook, AL

Diversification in Investing


DisclaimerAndreas 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.



What is diversification?

The key is asset allocation

Match appropriate asset allocation to specific financial goal


The Principle of Diversificationcombining 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) Riskunsystematic risk can be eliminated by diversificationunsystematic risk = diversifiable risk

Diversification and Systematic Risksystematic risk cannot be eliminated by diversificationsystematic risk = undiversifiable risk (market risk)

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

6Diversification From Combining Investments


No Diversification

PortfolioComplete Diversification


Some Diversification


7What Is Asset Allocation?Process of diversifying portfolio investments among several investment categories to reduce investment riskExample: 50% stock, 30% bonds, 20% cash assets (e.g., Treasury bills)Objective: lower investment risk by reducing portfolio volatilityLoss in one investment may be offset by gains in another

8Determinants of Portfolio Performance

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


9The Importance of Asset AllocationAsset 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.

10Why 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

11Factors To ConsiderInvestment objective (e.g., retirement)Time horizon for a goal (e.g., life expectancy for retirement)Amount of money you have to investYour risk tolerance and experienceYour age and net worth

12Downside of Asset AllocationA 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

13Major Asset ClassesLarge company growth stocksLarge company value stocksSmall company growth stocksSmall company value stocksMid cap growth stocksMid cap value stocksForeign stocksDeveloped EmergingBondsDomesticInternationalReal estate (e.g., REITs)Cash assets (e.g., CDs, Treasury bills)

Pyramid of Investment Risk


15The Asset Allocation ProcessDefine goals and time horizonAssess your risk toleranceIdentify asset mix of current portfolioCreate target portfolio (asset model)Specific investment selectionReview and rebalance portfolio

16Other Things to Know About Asset AllocationPortfolio risk decreases as the # of asset classes increases

Best results are achieved over time

Diversify holdings within each asset categoryStock: different industry sectorsBonds: different types and maturities

17More Asset Allocation TipsStick 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%

Sheet1Asset AllocationSecurity SelectionMarket TimingOther91.


Asset Allocation91.5%Other2.1%Market Timing1.8%Security Selection4.6%


&RSterling Financial Planning, Inc.




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