“Our portfolio is well-diversified. It’s 30% hopes,
30% wishes, and 40% prayers.”
- Be introduced to the technique of diversification as the major method to reduce risk
- Reexamine the relationship of risk and return
- Examine the role of correlation in assigning risk measurements to asset classes
- Explore the negative correlation, also called the inverse relationship, of stock and bond returns
- Examine the uses of the techniques of asset allocation, portfolio rebalancing, and dollar-cost averaging to help reduce risk
- Reexamine the role of mutual funds in reducing risk
By the end of this chapter and the Canvas module or class website, you should be able to
- Identify the advantages of a well-diversified portfolio
- Explain the relationship of risk and return and the role of correlation in assigning risk measurements to various asset classes
- Describe the typical negative correlation between stocks and bond and how a diversified portfolio of stocks and bonds can actually help create a portfolio that is less risky than either all stocks or all bonds
- Utilize the techniques of asset allocation, portfolio rebalancing, and dollar-cost averaging to help reduce risk
- Describe the role that mutual funds have in reducing risk and how many investors typically sabotage their long-term mutual fund results
It is Time to Reflect and Assimilate
Congratulations! We have covered the most important investment alternatives for the vast majority of investors. It is time now to go back to the very beginning of the semester and tie everything together. We will reexamine the eternal struggle of risk versus return. We will see how a well-diversified portfolio can help us reduce risk while still offering us an attractive return. It turns out we can eat reasonably well and sleep reasonably well! We will also take a look at the techniques of asset allocation, portfolio rebalancing, and dollar-cost averaging and reexamine the role of mutual funds in diversification. We end with yet another example of what Mr. Benjamin Graham told us many years ago, “The investor’s chief problem, and even his worst enemy, is likely to be himself.”
- 11.1: Diversification and Portfolio Risk
- "Don't put all your eggs in one basket." But some folks disagree. They say, "Put all your eggs in one basket -- and watch that basket!"
- 11.2: Asset Allocation
- Asset allocation is the process of defining what percentages of the various investment alternatives an investor wants in their portfolio. How much should we have in stocks, bonds, "cash" short-term vehicles, and any other investments that might be attractive to the investor?
- 11.3: Dollar-Cost Averaging and Mutual Funds, Revisited
- Two other tools of investing that help us reduce risk are our old friends, dollar-cost averaging and mutual funds. Let's revisit them.
- 11.S: Summary
- Congratulations ‒ You Have Finished Chapter 11 ‒ Portfolio Diversification and Asset Allocation