As baseball teams prepare for the new season each spring, their managers puzzle over how to put together the best line-up they can. You face a similar challenge in assembling an investment portfolio.
A well-rounded baseball team is made up of differing yet complementary parts. There are sluggers and speedsters, starting pitchers and relievers, designated hitters and defensive specialists. A lot of thought goes into putting the right mix together, so a team will have a lefty specialist to face the opposing team's left-handed power hitter in the clutch, or perhaps have a reliable pinch hitter to send to the plate in the bottom of the ninth inning.
A good portfolio should have its share of complementary role players as well. Unfortunately, people tend to assemble portfolios based on a series of isolated decisions rather than by thinking how well all the pieces fit together. This often results in portfolios that are weighted too heavily in some areas, and underrepresented in others.
Here are some of the components -- or "players" -- that you might want in your portfolio. Depending on your objectives, you might need all of these players to win, but having most of them isn't likely to hurt.
1. Sector representation
The S&P 500 is made up of 10 different sectors, each representing a distinct area of the economy, such as technology, financials and so on. If you want a portfolio to be broadly representative of economic conditions, you should seek to own some investments in all these sectors. Even if you decide to avoid some sectors while weighting more heavily in others, that should be the result of a conscious choice based on the outlook for various industries, rather than a product of random selection.
2. Country diversification
As you build your portfolio, you might want to invest beyond U.S. borders. This may mean picking specific non-U.S. companies, or targeting the markets of particular countries based either on size or region-based opportunities. Either way, earmarking some of your portfolio for international investments helps the cause of diversification.
3. Capitalization differentiation
Size also can make a difference in the performance of stocks. Smaller companies are often earlier in their life cycles, and thus can be more dynamic -- though also riskier. Mixing in some smaller companies can give you a nice complement to the more mature components in your portfolio.
4. Income production
Having some of your portfolio generate consistent income through regular dividend or interest payments can both help you meet recurring needs for cash and add an element of consistency to your investment returns. However, in today's low-yield environment, income investing is not very rewarding. Savings account rates are near historic lows, and Treasury yields range from less than 1 percent to about 2.5 percent. High-quality corporate bonds are yielding about 3.6 percent and lower-quality corporate bonds are yielding about 4.5 percent, but you have to be cognizant that higher yields generally come with a higher default risk.
For the portion of your holdings that you want to be there for you no matter what, there is nothing you can do except bite the bullet and accept low bank rates by keeping some money in an FDIC-insured saving or money market account.
If you want complete security but do not need immediate liquidity, consider introducing an FDIC-insured certificate of deposit (CD). A longer-term CD will likely beat your savings account's rate without exposing those funds to market fluctuations.
7. Risk hedges
This involves taking a specific risk to which you are exposed and finding a suitable way to counterbalance that risk. For example, suppose your business entails a lot of of energy consumption. In that case, you might find investing in oil futures or oil company stocks to be an appropriate hedge.
8. Noncovariant elements
This takes the concept of diversification a step further by investing in things specifically because they tend to perform differently from one another. Be careful though -- history is not always a reliable guide to how investments will perform in the future, so focus on fundamental economic reasons for why certain investments can be expected to behave differently.
9. Growth and value components
Growth investing means focusing on companies with dynamic earnings growth, even if it means paying a high price for them. Value investing entails focusing on stocks trading at cheap valuations, even if the company may be out of favor when you buy it. Both approaches have their pluses and minuses, so consider an approach that makes room for both growth and value investments in your portfolio.
Building a portfolio based on the specific role of each investment not only gives you a better chance of having a well-rounded portfolio, but it also should help you be more focused and purposeful about each individual investment choice you make. That's the kind of planning that goes into creating a winning team.
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