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By Robert Miehm | 08-17-2018

Using multi-asset portfolios for diversification

Aggressive portfolios typically have less diversification than conservative ones, so their return variations are greater.

Robert Miehm: Diversification within a portfolio means holding a variety of assets whose performance patterns are not too similar (or correlated) with the other assets in the portfolio.

If you are just holding one asset, you are taking on concentration risk, or the risk that the asset may fall in value or become worthless. If you hold a few assets that perform differently under various economic conditions, your risk of losing money would, at least, be curtailed. You'll have some assets that perform well and maybe others not so well. The good performers will help offset some of the poor performers in the portfolio.

Here in the chart are a few ways you could diversify. Within an asset class you could diversify by industry group. Across asset classes you could diversify using stocks, bonds, commodities, and cash. And you could also diversify across countries, not only buying domestic securities, but also international securities.

Let's have a look at a few target-risk, multi-asset portfolios to see how they can be diversified across asset classes. Looking at target risk profiles from Conservative to Aggressive you can see that in the Aggressive Growth profile there are typically fewer asset classes represented, less diversification, and in the Conservative portfolio there are typically additional asset classes, representing more diversification.

The best one-year return over a long-time horizon in the Aggressive Growth portfolio, which has a target 95% equity allocation, is likely to be strong, but the worst one-year performance over a long-time horizon is also likely to be extremely weak. The Conservative portfolio will also have performance ups and downs but not nearly as wide ranging, or volatile, as you'd see in Aggressive Growth and part of this lower volatility would be due to the additional diversity that the Conservative portfolio is likely to have.

Depending on your willingness and ability to take on various levels of risk at different points in your life, you should find yourself fitting into one of these diversifying allocations. Diversification will help alleviate some of the concentration risk that you may have otherwise taken on, and hopefully add to your comfort level.

For Morningstar Investment Management, I'm Rob Miehm.

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