Warrington Shaw is a staunch advocate of Modern Portfolio Theory. This means we judiciously adhere to tenets like asset allocation and proper diversification when we plan portfolios that respect our clients' tolerance for investment risk while, at the same time, ensuring that a portfolio has the best chance of achieving the long-term objectives agreed upon during our initial consultations.
Risk vs Reward
For the uninitiated, "asset allocation" and "diversification" tend to sound rather boring as concepts but, when it comes to the business of mitigating investment risk in portfolios, they are essential.
Put simply, asset allocation is a strategy that fosters a compromise between risk and reward. Basically, the portfolio's assets are distributed so that they achieve the investor's objectives in a given time horizon while respecting his or her risk tolerance.
In layman's terms, it means dividing money between asset classes like stocks, bonds, commodities, mutual funds in quantities that best meet the investor's risk tolerance guidelines.
Hedging Your Bets
Diversification is essential because, over time, certain investment types and individual investments have a tendency to perform differently and in doing so, they can expose your portfolio to fluctuations that can be hard to predict.
For instance, if your portfolio features investments in stocks and the stock market experiences a sharp correction then, any loss you may suffer could potentially be softened by appreciation in the other assets in the portfolio. In this scenario, the portfolio's bond holdings could yield gains since investors usually divert capital into bonds when stocks sell off.