To achieve successful outcomes when constructing a portfolio, it is important to understand the basics of diversification and how this may optimize returns, reduce risk, and create non-correlations.
We have been taught for years that a properly diversified portfolio focuses on one important factor: the percentage of bonds vs equities one has in their portfolio. You may hear advisors speak to a diversified portfolio that is weighted 60% bonds vs 40% equities, or a "60/40" portfolio. The more bonds you have in a portfolio, the more conservative you are positioned; and vice versa, the more equities you have, the more risk you are taking. This would assume that anything moving away from a 50/50 equally weighted bond to equity portfolio would result in less diversification.
While in theory this sounds logical, there are many other important factors to consider when determining how to properly diversify a portfolio. In fact, a "60/40" bond to equity portfolio may be far riskier than a 100% equity portfolio due to the nature of the bonds held within that portfolio. Each of the concepts below should be a taken into consideration with one’s time horizon, risk tolerance, liquidity, and Income needs.
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