business Personal FinanceWall Street 101

Introduction | Tips For Getting Diversified | Appropriate Diversification | Maximum Portfolio | Investments That Reduce Risk | Assest Class Mixes

Diversify

Getting Into Investments That Reduce Risk

Modern Portfolio Theory considers the total performance of an investor's account. When you plan your investments, consider the shape of the whole account. Don't think about how risky an individual stock or bond is, but about how risky it makes your whole bundle of investments.

The risk, or fluctuation in return, of your total investment account can be derived mathematically. It depends on two factors -- the risk of each individual investment and the correlation between the investments.

It is that second factor that many investors forget about when determining their risk. The risk of your total portfolio is not simply the average risk of all the individual securities. To gauge your risk picture accurately, you must understand that assets don't all go up or down at the same time.

We've already mentioned correlation. When two assets are positively correlated, they move in the same pattern. More importantly, when they are negatively correlated, they move in opposite patterns, as in the graph above. This "zig-zag" effect allows you to balance your investments, so that one investment, in theory, will always be rising when another is falling (in practice, securities don't move so neatly or predictably).

So, remember this crucial point when you are shaping your investment portfolio: the less your assets move together, the better off you will be.


The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.
Copyright © 1996 - 2000 mPower. All Rights Reserved.