Building a successful investment portfolio is like making a good stew: Different ingredients combine to produce a positive result that is much more than just the sum of its parts.
Many people believe that the more investments you have in your portfolio, the stronger it will be. They are wrong. Just as different ingredients come together in a stew to make a great meal, different types of investments combine to strengthen a portfolio. This is known as diversification.
Varying the ingredients in your portfolio will often reduce risk because different asset types tend to be affected differently by the same market and economic factors. Because of its lower risk, a diversified portfolio tends to give better returns by helping you avoid or withstand big hits that can be hazardous to your wealth.
Portfolios also need diversity within each asset type. Take stocks, for example. You can own 400 stocks, but if they're all in one industry — say, tech — they will all be negatively affected by the same economic and market factors. Owning 20 stocks in different industries substantially reduces risk. So, not only should you make sure that your portfolio contains different types of assets, but also different types of stocks.
Doubling up on some types of investments and omitting others throws off the diversification recipe. This error is typical in 401(k) plans.
A well-diversified stock portfolio contains small, medium and large companies, as well as some international stocks. But when choosing their 401(k) plan investments, people often unwittingly buy several mutual funds that hold the same types of stocks — if not the same companies.
Typically, they do this because they're chasing last year's returns. If small-company stocks did well last year, chances are that funds containing these stocks outperformed, too. So investors end up buying several funds that have all-too-similar holdings. To assemble a diversified portfolio, you must know what's in it.
Though everyone's portfolio should be highly diversified, a good portfolio for one person may be a terrible one for another. What's right for you depends on your age, goals and tolerance for risk. Typically, a 30-year-old who isn't planning to retire for 35 years would have different investing goals than a 55-year-old, and a far greater risk tolerance. If the younger investor loses a lot of money in the stock market, he has more time to make it up before retirement. So he would typically have far more of his total portfolio in stocks than the 55-year-old.
The older investor, planning to retire in 10 years, would likely have a proportionately greater investment in bonds because their returns, though historically lower than stocks', tend to be more reliable. Yet risk tolerance isn't determined by age alone; two investors of the same age can have far different tolerances. If an investor has aggressive goals for returns, he or she should have a high risk tolerance to match.
Risk tolerance shouldn't be confused with loss tolerance. Risk tolerance means your comfort level in dealing with the concept of loss. Loss tolerance is your capacity to deal with losing money when it actually happens.
If you overestimate your risk tolerance, you could end up experiencing losses that you aren't psychologically capable of handling. This happened after the market meltdown of 2008, when many investors who suffered substantial losses found that they'd assembled their portfolios too boldly.