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ProActiveFinancialPlanning.com |
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The Financial Planning Center Comprehensive Financial Planning
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How to Manage Your Investment Risk |
Diversification vs. Asset Allocation-How to Manage Your Risk?
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Common Investment Mistakes or Poor Investment Decisions?
Diversification vs. Asset Allocation-Managing Investment Risk Hope for the Best but Plan for the Worst Summary |
Asset Allocation (based on the Markowitz Portfolio Theory) Once you have established the asset classes in your strategically
diversified portfolio, how do you determine the weight allocated to
each security? The
question leads us to infinite possibilities with each weighting
leading to its own unique expected return and expected level of risk
(variability measured by standard deviation).
Portfolio risk encompasses not only the individual security
returns, but also the variance of each security, the covariance
between securities, and the portfolio weights for each security.
Using these inputs, we can calculate the portfolio with the
smallest variance (risk) for a given level of expected return.
This becomes your benchmark portfolio that falls on the
efficient frontier. The efficient frontier is a series of points on a chart
created by the intersection of x & y values that express the
highest return (y-axis) given a level of risk (x-axis).
Any point you select on the efficient frontier based on the
risk and return trade off, will determine the weighting of each asset
class. The beauty of this method of investing is that it does not depend
on either the credibility of an analyst or the accuracy of a
company’s financial statements.
It also takes investment decisions based on fear and greed out
of the equation. Other
than rebalancing your asset allocation periodically, it is not
necessary to predict market bottoms or tops.
When you attempt to pick market bottoms or tops, you are
gambling. No one has ever
consistently picked market peaks and troughs, although some may be
better than others. The
accurateness of this investment strategy is based on the accuracy of
the inputs. The inputs
are future projections based on the past performance and the
covariance of asset classes included in your portfolio.
Here is the uncertainty. Although
we can use data dating back to the early 1900s to determine the
historic average returns and use that data to determine the
interrelationship of the returns between asset classes, the best we
can do is make a calculated assumption for the future.
Although using historic returns to predict future returns may
be a logical assessment, past performance will not guarantee future
performance. Once a benchmark portfolio has been established, you may want to
fine-tune your asset weightings
according to current and expected market conditions.
If you do not have an economic or financial background to
adequately assess the economy, you may want to consult a professional.
This module is available by email in a seven-page, printable version upon request. Contact ProActive Financial Planning to Request.
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