In a hypothetical example, given someone who has average risk tolerance, and tha

Question

In a hypothetical example, given someone who has average risk tolerance, and that person needs to diversify, explain how the effects of portfolio risk for average stocks should impact their future investment decisions and why. Please show how this person should strategically invest their money if they have 100,000 in the bank to invest and they needed to diversify their portfolio.

Given: A person today has 100,000 today in a savings account and they want to invest their money in a diverse stragegy over a period of 20 years. How can they maximize their money. Pretend it was you. Would you put it all on one fund or would you use have it split among a few. Which ones? What would that 100,000 today look like in 20 years.

Explanation / Answer

First, we need to consider investment. When will funds be needed? If the time horizon is relatively short, risk tolerance should shift to be more conservative. For long-term investments, there is room for more aggressive investing. With today's growing life expectancies and advancing medical science, the 65-year-old investor may still have a 20-year (or more) time horizon.

Net worth and available risk capital should be important considerations when determining risk tolerance. Net worth is simply your assets minus your liabilities. Risk capital is money available to invest or trade that will not affect your lifestyle if lost. It should be defined asliquid capital, or capital that can easily be converted into cash.

Therefore, an investor or trader with a high net worth can assume more risk. The smaller the percentage of your overall net worth the investment or trade makes up, the more aggressive the risk tolerance can be.

Spreading your risk around, even if it is all high risk, decreases your overall exposure to any single investment or trade. With appropriate diversification, the probability of total loss is greatly reduced. This comes back to preservation of capital.

Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries and other categories. It aims to maximize return by investing in different areas that would each react differently to the same event. Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk.

It's also important that you diversify among different asset classes. Different assets - such asbonds and stocks - will not react in the same way to adverse events. A combination of asset classes will reduce your portfolio's sensitivity to market swings. Generally, the bond andequity markets move in opposite directions, so, if your portfolio is diversified across both areas, unpleasant movements in one will be offset by positive results in another.

There is a debate over how many stocks are needed to reduce risk while maintaining a high return. The most conventional view argues that an investor can achieve optimal diversification with only 15 to 20 stocks spread across various industries.

Diversification can help an investor manage risk and reduce the volatility of an asset's price movements. Remember though, that no matter how diversified your portfolio is, risk can never be eliminated completely. You can reduce risk associated with individual stocks, but general market risks affect nearly every stock, so it is important to diversify also among different asset classes. The key is to find a medium between risk and return; this ensures that you achieve your financial goals while still getting a good night's rest.

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