Newspaper article Sarasota Herald Tribune

Four Tools Every Investor Needs

Newspaper article Sarasota Herald Tribune

Four Tools Every Investor Needs

Article excerpt

THE RATIONAL INVESTOR

Serious professionals like plumbers and electricians all have toolboxes, and the basic tools are the same in each craft's toolbox. Similarly, serious investors need a "toolbox" that can help them be successful more consistently. Like craftsmen, they need to understand their tools: what tool for what job; how to use it correctly; what outcome to realistically expect from using it.

Space limitations allow discussion of only four of the many tools available to investors:

- Diversification within an asset class.

- Diversification across asset classes.

- Portfolio rebalancing.

- Time sensitive asset allocation.

For investors sensitive to temporary portfolio losses due to normal market volatility, these tools are essential but they aren't cost free.

Recall that an asset class is a group of investments that behave somewhat similarly. Classical asset classes are stocks, bonds and cash. Why would an investor want to diversify within an asset class?

Suppose an investor bought only one stock. Even if the market rose, that stock might fall due to some issue particular to that stock. This illustrates that every stock is subject to two kinds of risk -- overall stock market volatility risk and risks specific to that stock.

Buying several stocks doesn't change the overall stock market volatility risk, but carefully selecting them can lower a portfolio's stock risk. For example, if an investor buys a technology stock and a bank stock, it's unlikely that disappointing earnings in the technology stock due to loss of a major contract would indicate anything about earnings of bank stocks.

But diversifying within an asset class isn't enough. Asset allocation is a tool used to limit overall portfolio volatility by dividing investments across the different asset classes.

This happens for two reasons. First, bonds have lower volatility than stocks, while cash is essentially volatility free. …

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