The key questions to ask as you devise a diversification strategy are about your goals and your appetite for risk. Since assets with higher risks generally produce higher returns, these questions are intimately related. Investing is a long-term strategy, and it makes sense to think about your goals in the long term. Investors’ goals are often tied to life events—buying a larger house when you have children, sending the children to college, retiring, creating an estate, and probably a few more crucial moments. Not all the events in life are predictable, and you will regularly need to reassess your holdings. There may come periods of time or major life events when you want to radically alter the structure of your portfolio, possibly by making investments with maturity dates synchronized with those events. Being vigilant in keeping up with your portfolio will help ensure that your investments are on track with where you are in your life.
It is often the case (although by no means a rule) that younger investors have a greater tolerance for risk. With decades to ride out market cycles and refine your investing strategy, higher risks with larger returns are tempting. As you approach retirement, however, security becomes a greater priority, and your investment strategy is likely to change to reflect that.
In any case, you need to target a risk level with your diversification strategy, and zero risk is not an option. No risk would mean no losses, but it would also mean no returns. Diversification doesn’t guarantee against losses. That’s not even a goal of diversification. Rather, you are attempting to balance out your losses to keep your portfolio performing as you envision it.
The mechanics of diversification can be quite complex. You are looking at actions like allocating your investments among asset classes, analyzing the performance of individual assets, tracking market cycles and reacting to market corrections. These activities can be guided by complex mathematical formulae within a theoretical framework, as well as practical strategies that balance risk against expected returns through varying management philosophies. Professional guidance is recommended for most investors, especially those with limited experience.
Even with professional management, you want to understand your choices and make an informed decision. It is worth repeating that this is a highly complex topic, but here are the basics.