Building a Diversified Portfolio: how do you Balance Risk and Return?

When it comes to investing, managing risk is just as important as seeking returns. A well-thought-out investment strategy should incorporate a mix of asset classes that align with your risk tolerance, financial goals, and time horizon. By spreading your investments across different types of assets, you reduce the impact of volatility in any one area of the market. This strategy, known as diversification, is a key factor in building wealth and protecting your portfolio from significant downturns.

Why Diversification Matters

Diversification helps manage risk by ensuring your investments aren't tied to the performance of a single asset class. When one part of the market is down, another may be performing well. This balance helps smooth out returns over time and reduces the chance of significant losses. The aim is to have a portfolio that can withstand market volatility while still generating returns in line with your financial objectives.

Components of a Diversified Portfolio

A typical diversified portfolio includes a variety of asset classes, each with its own risk and return characteristics. The main asset classes you should consider are:

• Equities (shares): Representing ownership in companies, equities offer the potential for long-term capital growth. They tend to be more volatile than other asset classes, but they also offer higher potential returns over time.
• Fixed Income (bonds): These are debt instruments issued by governments or corporations. Bonds provide regular interest payments and are generally considered lower risk compared to equities. They can offer stability to a portfolio, particularly in times of market uncertainty.
• Cash: Cash and cash equivalents (such as savings accounts and money market funds) provide liquidity and safety. However, the returns are typically lower, particularly in a low-interest-rate environment.
• Property and Infrastructure: Investing in real estate and infrastructure assets can provide both capital growth and income. These investments often have a lower correlation with equities, making them useful in reducing portfolio volatility.
• Alternative Investments: These may include commodities, hedge funds, private equity, or other non-traditional assets. Alternatives can provide additional diversification and help protect against market downturns, although they often carry higher risk and lower liquidity.

Managing Risk Through Asset Allocation

The mix of these asset classes in your portfolio is known as asset allocation. This allocation should reflect your personal risk tolerance, investment objectives, and time horizon. For example, a younger investor with a long time until retirement may be more comfortable with a higher allocation to equities, which offer growth potential but come with higher risk. Conversely, someone nearing retirement might prefer more bonds and cash to preserve capital and reduce risk.

A typical portfolio for a balanced investor might include 50% equities, 30% fixed income, 10% property and infrastructure, and 10% cash or alternatives. However, this mix should be regularly reviewed and adjusted based on market conditions and changes in your personal situation.

The Role of Alternative Investments in Managing Risk

While equities and bonds are often the mainstays of a portfolio, alternative investments can play a significant role in managing risk and enhancing returns. Alternatives, such as commodities, private equity, or hedge funds, offer unique return profiles that can perform well when traditional asset classes are struggling. For example, during periods of rising inflation, commodities may perform better than equities or bonds, providing a hedge against inflation risk.

However, it’s essential to be aware that alternative investments often come with higher risks and lower liquidity. As such, they should form only a part of a well-diversified portfolio, especially for more conservative investors.

Diversified Portfolio Returns

Let’s assume you’ve built a diversified portfolio with the following asset allocation:

• 50% equities
• 20% fixed income
• 10% cash
• 10% property
• 10% alternative investments

Now, let's calculate potential returns based on the following hypothetical annual growth rates:

• Equities: 8%
• Fixed Income: 4%
• Cash: 2%
• Property: 6%
• Alternatives: 6%

Here's how the overall portfolio return would look:

• Equities: 50% × 8% = 4.0%
• Fixed Income: 20% × 4% = 0.8%
• Cash: 10% × 2% = 0.2%
• Property and Alternatives: 20% × 6% = 1.2%

This gives you a total blended annual return of approximately 6.2%. Of course, actual returns will vary depending on market conditions and your specific investments, but this example illustrates how asset allocation can influence the overall performance of a portfolio.

Key Considerations

• Understand your financial goals, risk tolerance, and time horizon before setting up an investment strategy.
• A diversified portfolio can help manage risk by spreading exposure across multiple asset classes.
• Regularly review and adjust your portfolio based on changes in your financial situation or market conditions.
• Balance growth-oriented assets (such as equities and property) with more defensive assets (such as bonds and cash) to achieve the right risk-return profile.
• Alternative investments can offer further diversification but should be used carefully to avoid unnecessary risk.

Constructing a well-diversified portfolio is essential for managing risk and optimising returns. By thoughtfully selecting and balancing different asset classes, you can navigate market fluctuations more confidently and work toward achieving your long-term financial goals.

Navigating financial decisions can be complex, and my focus is on building long-term relationships built on trust and understanding to help achieve the best outcomes for you.

Whether you have questions, need guidance, or just want to share your thoughts, please feel free to reach out. I genuinely value the opportunity to work together and assist you in reaching your financial goals.

General advice disclaimer.

The information in this graphic is of a general nature and does not take into account your own financial objectives, circumstances or needs. You should consider your own personal situation and requirements before making a decision. If you have concerns or questions, please contact me/us.

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