Diversification: One Way to Reduce the Impact of Volatility

When you invest in the market, the one thing you can be sure of is that it will fluctuate in ways no one can predict - it is the nature of the market. Since the market is unpredictable and volatile, you will want to have a strategy in place to minimize the impact of volatility. Creating a diversified portfolio is one way that investors can reduce the risk of significant loss due to negative returns from any one investment by spreading their assets over many investments.

To create a well-diversified portfolio, you can begin with considering three asset classes: equity, fixed income, and cash. Stocks, or equity investments, carry the most risk, but may also have the most potential for high returns. Bonds are considered fixed income, and are less risky with lower potential returns. Cash investments have the lowest risk, and generally the lowest return. Choosing how much of your assets you would like to allocate to each class determines your portfolio balance. Within each class, you can diversify your portfolio even further by choosing a mix of investments that fall into that class.

When selecting investments to create a diversified portfolio, the following factors can help you choose an appropriate mix for your goals:

Know your risk tolerance. One of the keys to investing is knowing the level of risk you are comfortable with. If you take on too much risk, you might feel unprepared for market fluctuations and make sudden changes during volatile periods that could negatively affect your portfolio over time. Choosing investments that carry a level of risk you are comfortable with will help you maintain the investing strategy you've chosen through market ups and downs.

Determine your time horizon. The amount of time you have to invest before you expect to begin using the money will affect the type of investments you choose. You may be comfortable with more risk if your estimated retirement date is farther away, since your assets would have more time to recover from short-term market fluctuations. On the other hand, you may prefer to choose lower-risk options if you do not have a lot of time to recover from short-term market fluctuations or if you are uncomfortable with significant volatility. In any case, your time horizon can be one of the most important factors affecting your investing choices.

Choose a mix of mutual funds. Most mutual funds hold a highly-diversified portfolio of stocks from many different companies, chosen to reflect different investment objectives. Different mutual funds invest in different types of securities, and they also have different levels of risk, so that investors can choose funds appropriate for their goals. Selecting a mix of mutual funds allows investors who want to diversify to take advantage of the built-in diversification within each fund as well as additional diversification among funds that have different objectives and strategies.

Consider the funds' market capitalization. Market capitalization refers to size of a company, which is grouped into three main categories: large, mid, and small cap. Typically, large capitalization stocks are generally less risky than mid and small capitalization stocks. If you are comfortable with the risk of investing in stocks but have a low tolerance for risk, you may want to reduce the amount you have invested in small cap, since small cap stocks tend to fluctuate more than mid or large cap stocks.

Review the funds' investment style. Two common types of investment styles are growth and value. Basically, growth investors seek fast-growing companies and value investors look for bargains. Having a balanced portfolio between these two styles can help protect your assets from market volatility.

Diversification is a safeguard that can help some investors keep their portfolios invested in a way that aligns with their goals. If you want to diversify your portfolio, you can choose mutual funds that are right for you by looking at their objectives and investment strategies, which are found in each fund's prospectus. After carefully considering your time horizon to invest and your comfort level with risk, choosing a range of different investments is one strategy that can help protect your assets from - and help you feel more prepared for - short-term market ups and downs.