Slicing Up the Stock and Bond Pies
Step 1: Can My Portfolio Allocation Reduce Risk Without Lowering My Return?
Once you have decided on your portfolio allocation among the three major asset categories–stocks, bonds and cash–your most important work is over. Yet, your portfolio at this point is only broadly sketched. It is now time to rough in a few details.
To review the major risks facing the three asset categories:
Can My Portfolio Allocation Reduce Risk Without Lowering My Return?
Why Should I Diversify Between Large Stocks, Small Stocks, and Foreign Stocks?
How Can I Use Different Types of Bonds to Reduce Interest Rate Risk?
How Do I Determine the Right Allocation for My Portfolio?
- Business and industry risk
is high for both stocks and bonds, but can be eliminated by diversifying among different stocks with different industry groups.
- Inflation risk
for bonds is high, but can be reduced by including stocks in the overall portfolio;
- Liquidity risk
is high for stocks and bonds, but within an investor's portfolio it can be reduced by including cash (money market and short-term certificates of deposit).
That leaves stock market and interest rate risk as the major risks facing investors. Stock market risk is due to the volatility of the overall market, which can cause even attractive stocks to drop in price. Interest rate risk is due to the sensitivity of bond prices to changes in interest rates–rising interest rates cause existing bonds to drop in value.
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