{"id":349,"date":"2018-11-28T18:49:23","date_gmt":"2018-11-28T18:49:23","guid":{"rendered":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/?post_type=chapter&#038;p=349"},"modified":"2018-11-28T18:49:23","modified_gmt":"2018-11-28T18:49:23","slug":"diversification-return-with-less-risk","status":"publish","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/chapter\/diversification-return-with-less-risk\/","title":{"raw":"Diversification: Return with Less Risk","rendered":"Diversification: Return with Less Risk"},"content":{"raw":"<div id=\"fwk-134226-ch12_s04_n01\" class=\"learning_objectives editable block\">\r\n<div class=\"textbox learning-objectives\">\r\n<h3>Learning Objectives<\/h3>\r\n<ol id=\"fwk-134226-ch12_s04_l01\" class=\"orderedlist\">\r\n \t<li>Explain the use of diversification in portfolio strategy.<\/li>\r\n \t<li>List the steps in creating a portfolio strategy, explaining the importance of each step.<\/li>\r\n \t<li>Compare and contrast active and passive portfolio strategies.<\/li>\r\n<\/ol>\r\n<\/div>\r\n&nbsp;\r\n\r\n<\/div>\r\n<p id=\"fwk-134226-ch12_s04_p01\" class=\"para editable block\">Every investor wants to maximize return, the earnings or gains from giving up surplus cash. And every investor wants to minimize risk, because it is costly. To invest is to assume risk, and you assume risk expecting to be compensated through return. The more risk assumed, the more the promised return. So, to increase return you must increase risk. To lessen risk, you must expect less return, but another way to lessen risk is to diversify\u2014to spread out your investments among a number of different asset classes. Investing in different asset classes reduces your exposure to economic, asset class, and market risks.<\/p>\r\n<p id=\"fwk-134226-ch12_s04_p02\" class=\"para editable block\">Concentrating investment concentrates risk. Diversifying investments spreads risk by having more than one kind of investment and thus more than one kind of risk. To truly diversify, you need to invest in assets that are not vulnerable to one or more kinds of risk. For example, you may want to diversify<\/p>\r\n\r\n<ul id=\"fwk-134226-ch12_s04_l02\" class=\"itemizedlist editable block\">\r\n \t<li>between cyclical and countercyclical investments, reducing economic risk;<\/li>\r\n \t<li>among different sectors of the economy, reducing industry risks;<\/li>\r\n \t<li>among different kinds of investments, reducing asset class risk;<\/li>\r\n \t<li>among different kinds of firms, reducing company risks.<\/li>\r\n<\/ul>\r\n<p id=\"fwk-134226-ch12_s04_p03\" class=\"para editable block\">To diversify well, you have to look at your collection of investments as a whole\u2014as a portfolio\u2014rather than as a gathering of separate investments. If you choose the investments well, if they are truly different from each other, the whole can actually be more valuable than the sum of its parts.<\/p>\r\n\r\n<div id=\"fwk-134226-ch12_s04_s01\" class=\"section\">\r\n<h2 class=\"title editable block\">Steps to Diversification<\/h2>\r\n<p id=\"fwk-134226-ch12_s04_s01_p01\" class=\"para editable block\">In traditional portfolio theory, there are three levels or steps to diversifying: capital allocation, asset allocation, and security selection.<\/p>\r\n<p id=\"fwk-134226-ch12_s04_s01_p02\" class=\"para editable block\"><strong>Capital allocation<\/strong>[footnote]A strategy of diversifying a portfolio between risky and riskless assets.[\/footnote] is diversifying your capital between risky and riskless investments. A \u201criskless\u201d asset is the short-term (less than ninety-day) U.S. Treasury bill. Because it has such a short time to maturity, it won\u2019t be much affected by interest rate changes, and it is probably impossible for the U.S. government to become insolvent\u2014go bankrupt\u2014and have to default on its debt within such a short time.<\/p>\r\n<p id=\"fwk-134226-ch12_s04_s01_p03\" class=\"para editable block\">The capital allocation decision is the first diversification decision. It determines the portfolio\u2019s overall exposure to risk, or the proportion of the portfolio that is invested in risky assets. That, in turn, will determine the portfolio\u2019s level of return.<\/p>\r\n<p id=\"fwk-134226-ch12_s04_s01_p04\" class=\"para editable block\">The second diversification decision is <strong>asset allocation<\/strong>[footnote]The strategy of achieving portfolio diversification by investing in different asset classes.[\/footnote], deciding which asset classes, and therefore which risks and which markets, to invest in. Asset allocations are specified in terms of the percentage of the portfolio\u2019s total value that will be invested in each asset class. To maintain the desired allocation, the percentages are adjusted periodically as asset values change. <a class=\"xref\" href=\"#fwk-134226-ch12_s04_s01_f01\">Figure 12.11 \"Proposed Asset Allocation\"<\/a> shows an asset allocation for an investor\u2019s portfolio.<\/p>\r\n\r\n<div id=\"fwk-134226-ch12_s04_s01_f01\" class=\"figure large medium-height editable block\">\r\n\r\n[caption id=\"\" align=\"aligncenter\" width=\"898\"]<img src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/3745\/2018\/11\/14183806\/4eaa7737bd939cd2094bd1dd49653313.jpg\" alt=\"image\" width=\"898\" height=\"658\" \/> Figure 12.11 Proposed Asset Allocation[\/caption]\r\n\r\n<\/div>\r\n<p id=\"fwk-134226-ch12_s04_s01_p05\" class=\"para editable block\">Asset allocation is based on the expected returns and relative risk of each asset class and how it will contribute to the return and risk of the portfolio as a whole. If the asset classes you choose are truly diverse, then the portfolio\u2019s risk can be lower than the sum of the assets\u2019 risks.<\/p>\r\n<p id=\"fwk-134226-ch12_s04_s01_p06\" class=\"para editable block\">One example of an asset allocation strategy is <strong>life cycle investing<\/strong>[footnote]An investment strategy in which asset allocation is based on the investor\u2019s age or stage of life.[\/footnote]\u2014changing your asset allocation as you age. When you retire, for example, and forgo income from working, you become dependent on income from your investments. As you approach retirement age, therefore, you typically shift your asset allocation to less risky asset classes to protect the value of your investments.<\/p>\r\n<p id=\"fwk-134226-ch12_s04_s01_p07\" class=\"para editable block\"><strong>Security selection<\/strong>[footnote]The process of choosing individual securities to be included in the portfolio.[\/footnote] is the third step in diversification, choosing individual investments within each asset class. Here is the chance to achieve industry or sector and company diversification. For example, if you decided to include corporate stock in your portfolio (asset allocation), you decide which corporation\u2019s stock to invest in. Choosing corporations in different industries, or companies of different sizes or ages, will diversify your stock holdings. You will have less risk than if you invested in just one corporation\u2019s stock. Diversification is not defined by the number of investments but by their different characteristics and performance.<\/p>\r\n\r\n<\/div>\r\n<div id=\"fwk-134226-ch12_s04_s02\" class=\"section\">\r\n<h2 class=\"title editable block\">Investment Strategies<\/h2>\r\n<p id=\"fwk-134226-ch12_s04_s02_p01\" class=\"para editable block\">Capital allocation decides the amount of overall risk in the portfolio; asset allocation tries to maximize the return you can get for that amount of risk. Security selection further diversifies within each asset class. <a class=\"xref\" href=\"#fwk-134226-ch12_s04_s02_f01\">Figure 12.12 \"Levels of Diversification\"<\/a> demonstrates the three levels of diversification.<\/p>\r\n\r\n<div id=\"fwk-134226-ch12_s04_s02_f01\" class=\"figure large editable block\">\r\n\r\n[caption id=\"\" align=\"aligncenter\" width=\"1204\"]<img src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/3745\/2018\/11\/14183808\/f8f90290878454cea09c5a65a431d55c.jpg\" alt=\"image\" width=\"1204\" height=\"647\" \/> Figure 12.12 Levels of Diversification[\/caption]\r\n\r\n<\/div>\r\n<p id=\"fwk-134226-ch12_s04_s02_p02\" class=\"para editable block\">Just as life cycle investing is a strategy for asset allocation, investing in index funds is a strategy for security selection. Indexes are a way of measuring the performance of an entire asset class by measuring returns for a portfolio containing all the investments in that asset class. Essentially, the index becomes a <strong>benchmark<\/strong>[footnote]A standard, often an index of securities, representing an industry or asset class and used as an indicator of growth potential or as a basis of comparison for similar of disparate industries or assets.[\/footnote] for the asset class, a standard against which any specific investment in that asset class can be measured. An index fund is an investment that holds the same securities as the index, so it provides a way for you to invest in an entire asset class without having to select particular securities. For example, if you invest in the S&amp;P 500 Index fund, you are investing in the five hundred largest corporations in the United States\u2014the asset class of large corporations.<\/p>\r\n<p id=\"fwk-134226-ch12_s04_s02_p03\" class=\"para editable block\">There are indexes and index funds for most asset classes. By investing in an index, you are achieving the most diversification possible for that asset class without having to make individual investments, that is, without having to make any security selection decisions. This strategy of bypassing the security selection decision is called <strong>passive management<\/strong>[footnote]An investment strategy that does not include security selection within an asset class; the investment is expected to perform as well as the benchmark index.[\/footnote]. It also has the advantage of saving transaction costs (broker\u2019s fees) because you can invest in the entire index through only one transaction rather than the many transactions that picking investments would require.<\/p>\r\n<p id=\"fwk-134226-ch12_s04_s02_p04\" class=\"para editable block\">In contrast, making security selection decisions to maximize returns and minimize risks is called <strong>active management<\/strong>[footnote]An investment strategy that includes security selection within an asset class in order to outperform the asset class benchmark.[\/footnote]. Investors who favor active management feel that the advantages of picking specific investments, after careful research and analysis, are worth the added transaction costs. Actively managed portfolios may achieve diversification based on the quality, rather than the quantity, of securities selected.<\/p>\r\n<p id=\"fwk-134226-ch12_s04_s02_p05\" class=\"para editable block\">Also, asset allocation can be actively managed through the strategy of <strong>market timing<\/strong>[footnote]The practice of basing investment strategy on predictions of future market changes or on asset return forecasts.[\/footnote]\u2014shifting the asset allocation in anticipation of economic shifts or market volatility. For example, if you forecast a period of higher inflation, you would reduce allocation in fixed-rate bonds or debt instruments, because inflation erodes the value of the fixed repayments. Until the inflation passes, you would shift your allocation so that more of your portfolio is in stocks, say, and less in bonds.<\/p>\r\n<p id=\"fwk-134226-ch12_s04_s02_p06\" class=\"para editable block\">It is rare, however, for active investors or investment managers to achieve superior results over time. More commonly, an investment manager is unable to achieve consistently better returns within an asset class than the returns of the passively managed index.<span id=\"fwk-134226-fn12_005\" class=\"footnote\">Much research, some of it quite academic, has been done on this subject. For a succinct (and instructive) summary of the discussion, see Burton G. Malkiel, <em class=\"emphasis\">A Random Walk Down Wall Street<\/em>, 10th ed. (New York: W. W. Norton &amp; Company, Inc., 2007).<\/span><\/p>\r\n\r\n<div id=\"fwk-134226-ch12_s04_s02_n01\" class=\"key_takeaways editable block\">\r\n<div class=\"textbox key-takeaways\">\r\n<h3>Key Takeaways<\/h3>\r\n<ul id=\"fwk-134226-ch12_s04_s02_l01\" class=\"itemizedlist\">\r\n \t<li>Diversification can decrease portfolio risk through choosing investments with different risk characteristics and exposures.<\/li>\r\n \t<li>\r\n<p class=\"para\">A portfolio strategy involves<\/p>\r\n\r\n<ul id=\"fwk-134226-ch12_s04_s02_l02\" class=\"itemizedlist\">\r\n \t<li>capital allocation decisions,<\/li>\r\n \t<li>asset allocation decisions,<\/li>\r\n \t<li>security selection decisions.<\/li>\r\n<\/ul>\r\n<\/li>\r\n \t<li>Active management is a portfolio strategy including security selection decisions and market timing.<\/li>\r\n \t<li>Passive management is a portfolio strategy omitting security selection decisions and relying on index funds to represent asset classes, while maintaining a long-term asset allocation.<\/li>\r\n<\/ul>\r\n<\/div>\r\n<\/div>\r\n<div id=\"fwk-134226-ch12_s04_s02_n02\" class=\"exercises editable block\">\r\n<h3 class=\"title\">Exercises<\/h3>\r\n<ol id=\"fwk-134226-ch12_s04_s02_l03\" class=\"orderedlist\">\r\n \t<li>What is the meaning of the expressions \u201cdon\u2019t count your chickens before they hatch\u201d and \u201cdon\u2019t put all your eggs in one basket\u201d? How do these expressions relate to the challenge of reducing exposure to investment risks and building a high-performance investment portfolio? View ING\u2019s presentation and graph on diversification and listen to the audio at <a class=\"link\" href=\"http:\/\/www.ingdelivers.com\/pointers\/diversification\" target=\"_blank\" rel=\"noopener\">http:\/\/www.ingdelivers.com\/pointers\/diversification<\/a>. In the example, how does diversification lower risk? Which business sectors would you choose to invest in for a diversified portfolio?<\/li>\r\n \t<li>Draft a provisional portfolio strategy. In My Notes or your personal finance journal, describe your capital allocation decisions. Then identify the asset classes you are thinking of investing in. Describe how you might allocate assets to diversify your portfolio. Draw a pie chart showing your asset allocation. Draw another pie chart to show how life cycle investing might affect your asset allocation decisions in the future. How might you use the strategy of market timing in changing your asset allocation decisions? Next, outline the steps you would take to select specific securities. How would you know which stocks, bonds, or funds to invest in? How are index funds useful as an alternative to security selection? What are the advantages and disadvantages of investing in an index fund such as the Dow Jones Industrial Average? (Go to <a class=\"link\" href=\"http:\/\/money.cnn.com\/data\/markets\/dow\/\" target=\"_blank\" rel=\"noopener\">http:\/\/money.cnn.com\/data\/markets\/dow\/<\/a> to find out.)<\/li>\r\n \t<li>Do you favor an active or a passive investment management strategy? Why? Identify all the pros and cons of these investment strategies and debate them with classmates. What factors favor an active approach? What factors favor a passive approach? Which strategy might prove more beneficial for first-time investors?<\/li>\r\n \t<li>View the online video blog \u201c3 Keys to Investing\u201d at <a class=\"link\" href=\"http:\/\/www.allbusiness.com\/personal-finance\/4968227-1.html\" target=\"_blank\" rel=\"noopener\">http:\/\/www.allbusiness.com\/personal-finance\/4968227-1.html<\/a>. What advice does the speaker, Miranda Marquit (October 26, 2007), have for novice investors? According to this source, what are the three keys to successful investing?<\/li>\r\n<\/ol>\r\n<\/div>\r\n<\/div>","rendered":"<div id=\"fwk-134226-ch12_s04_n01\" class=\"learning_objectives editable block\">\n<div class=\"textbox learning-objectives\">\n<h3>Learning Objectives<\/h3>\n<ol id=\"fwk-134226-ch12_s04_l01\" class=\"orderedlist\">\n<li>Explain the use of diversification in portfolio strategy.<\/li>\n<li>List the steps in creating a portfolio strategy, explaining the importance of each step.<\/li>\n<li>Compare and contrast active and passive portfolio strategies.<\/li>\n<\/ol>\n<\/div>\n<p>&nbsp;<\/p>\n<\/div>\n<p id=\"fwk-134226-ch12_s04_p01\" class=\"para editable block\">Every investor wants to maximize return, the earnings or gains from giving up surplus cash. And every investor wants to minimize risk, because it is costly. To invest is to assume risk, and you assume risk expecting to be compensated through return. The more risk assumed, the more the promised return. So, to increase return you must increase risk. To lessen risk, you must expect less return, but another way to lessen risk is to diversify\u2014to spread out your investments among a number of different asset classes. Investing in different asset classes reduces your exposure to economic, asset class, and market risks.<\/p>\n<p id=\"fwk-134226-ch12_s04_p02\" class=\"para editable block\">Concentrating investment concentrates risk. Diversifying investments spreads risk by having more than one kind of investment and thus more than one kind of risk. To truly diversify, you need to invest in assets that are not vulnerable to one or more kinds of risk. For example, you may want to diversify<\/p>\n<ul id=\"fwk-134226-ch12_s04_l02\" class=\"itemizedlist editable block\">\n<li>between cyclical and countercyclical investments, reducing economic risk;<\/li>\n<li>among different sectors of the economy, reducing industry risks;<\/li>\n<li>among different kinds of investments, reducing asset class risk;<\/li>\n<li>among different kinds of firms, reducing company risks.<\/li>\n<\/ul>\n<p id=\"fwk-134226-ch12_s04_p03\" class=\"para editable block\">To diversify well, you have to look at your collection of investments as a whole\u2014as a portfolio\u2014rather than as a gathering of separate investments. If you choose the investments well, if they are truly different from each other, the whole can actually be more valuable than the sum of its parts.<\/p>\n<div id=\"fwk-134226-ch12_s04_s01\" class=\"section\">\n<h2 class=\"title editable block\">Steps to Diversification<\/h2>\n<p id=\"fwk-134226-ch12_s04_s01_p01\" class=\"para editable block\">In traditional portfolio theory, there are three levels or steps to diversifying: capital allocation, asset allocation, and security selection.<\/p>\n<p id=\"fwk-134226-ch12_s04_s01_p02\" class=\"para editable block\"><strong>Capital allocation<\/strong><a class=\"footnote\" title=\"A strategy of diversifying a portfolio between risky and riskless assets.\" id=\"return-footnote-349-1\" href=\"#footnote-349-1\" aria-label=\"Footnote 1\"><sup class=\"footnote\">[1]<\/sup><\/a> is diversifying your capital between risky and riskless investments. A \u201criskless\u201d asset is the short-term (less than ninety-day) U.S. Treasury bill. Because it has such a short time to maturity, it won\u2019t be much affected by interest rate changes, and it is probably impossible for the U.S. government to become insolvent\u2014go bankrupt\u2014and have to default on its debt within such a short time.<\/p>\n<p id=\"fwk-134226-ch12_s04_s01_p03\" class=\"para editable block\">The capital allocation decision is the first diversification decision. It determines the portfolio\u2019s overall exposure to risk, or the proportion of the portfolio that is invested in risky assets. That, in turn, will determine the portfolio\u2019s level of return.<\/p>\n<p id=\"fwk-134226-ch12_s04_s01_p04\" class=\"para editable block\">The second diversification decision is <strong>asset allocation<\/strong><a class=\"footnote\" title=\"The strategy of achieving portfolio diversification by investing in different asset classes.\" id=\"return-footnote-349-2\" href=\"#footnote-349-2\" aria-label=\"Footnote 2\"><sup class=\"footnote\">[2]<\/sup><\/a>, deciding which asset classes, and therefore which risks and which markets, to invest in. Asset allocations are specified in terms of the percentage of the portfolio\u2019s total value that will be invested in each asset class. To maintain the desired allocation, the percentages are adjusted periodically as asset values change. <a class=\"xref\" href=\"#fwk-134226-ch12_s04_s01_f01\">Figure 12.11 &#8220;Proposed Asset Allocation&#8221;<\/a> shows an asset allocation for an investor\u2019s portfolio.<\/p>\n<div id=\"fwk-134226-ch12_s04_s01_f01\" class=\"figure large medium-height editable block\">\n<div style=\"width: 908px\" class=\"wp-caption aligncenter\"><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/3745\/2018\/11\/14183806\/4eaa7737bd939cd2094bd1dd49653313.jpg\" alt=\"image\" width=\"898\" height=\"658\" \/><\/p>\n<p class=\"wp-caption-text\">Figure 12.11 Proposed Asset Allocation<\/p>\n<\/div>\n<\/div>\n<p id=\"fwk-134226-ch12_s04_s01_p05\" class=\"para editable block\">Asset allocation is based on the expected returns and relative risk of each asset class and how it will contribute to the return and risk of the portfolio as a whole. If the asset classes you choose are truly diverse, then the portfolio\u2019s risk can be lower than the sum of the assets\u2019 risks.<\/p>\n<p id=\"fwk-134226-ch12_s04_s01_p06\" class=\"para editable block\">One example of an asset allocation strategy is <strong>life cycle investing<\/strong><a class=\"footnote\" title=\"An investment strategy in which asset allocation is based on the investor\u2019s age or stage of life.\" id=\"return-footnote-349-3\" href=\"#footnote-349-3\" aria-label=\"Footnote 3\"><sup class=\"footnote\">[3]<\/sup><\/a>\u2014changing your asset allocation as you age. When you retire, for example, and forgo income from working, you become dependent on income from your investments. As you approach retirement age, therefore, you typically shift your asset allocation to less risky asset classes to protect the value of your investments.<\/p>\n<p id=\"fwk-134226-ch12_s04_s01_p07\" class=\"para editable block\"><strong>Security selection<\/strong><a class=\"footnote\" title=\"The process of choosing individual securities to be included in the portfolio.\" id=\"return-footnote-349-4\" href=\"#footnote-349-4\" aria-label=\"Footnote 4\"><sup class=\"footnote\">[4]<\/sup><\/a> is the third step in diversification, choosing individual investments within each asset class. Here is the chance to achieve industry or sector and company diversification. For example, if you decided to include corporate stock in your portfolio (asset allocation), you decide which corporation\u2019s stock to invest in. Choosing corporations in different industries, or companies of different sizes or ages, will diversify your stock holdings. You will have less risk than if you invested in just one corporation\u2019s stock. Diversification is not defined by the number of investments but by their different characteristics and performance.<\/p>\n<\/div>\n<div id=\"fwk-134226-ch12_s04_s02\" class=\"section\">\n<h2 class=\"title editable block\">Investment Strategies<\/h2>\n<p id=\"fwk-134226-ch12_s04_s02_p01\" class=\"para editable block\">Capital allocation decides the amount of overall risk in the portfolio; asset allocation tries to maximize the return you can get for that amount of risk. Security selection further diversifies within each asset class. <a class=\"xref\" href=\"#fwk-134226-ch12_s04_s02_f01\">Figure 12.12 &#8220;Levels of Diversification&#8221;<\/a> demonstrates the three levels of diversification.<\/p>\n<div id=\"fwk-134226-ch12_s04_s02_f01\" class=\"figure large editable block\">\n<div style=\"width: 1214px\" class=\"wp-caption aligncenter\"><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/3745\/2018\/11\/14183808\/f8f90290878454cea09c5a65a431d55c.jpg\" alt=\"image\" width=\"1204\" height=\"647\" \/><\/p>\n<p class=\"wp-caption-text\">Figure 12.12 Levels of Diversification<\/p>\n<\/div>\n<\/div>\n<p id=\"fwk-134226-ch12_s04_s02_p02\" class=\"para editable block\">Just as life cycle investing is a strategy for asset allocation, investing in index funds is a strategy for security selection. Indexes are a way of measuring the performance of an entire asset class by measuring returns for a portfolio containing all the investments in that asset class. Essentially, the index becomes a <strong>benchmark<\/strong><a class=\"footnote\" title=\"A standard, often an index of securities, representing an industry or asset class and used as an indicator of growth potential or as a basis of comparison for similar of disparate industries or assets.\" id=\"return-footnote-349-5\" href=\"#footnote-349-5\" aria-label=\"Footnote 5\"><sup class=\"footnote\">[5]<\/sup><\/a> for the asset class, a standard against which any specific investment in that asset class can be measured. An index fund is an investment that holds the same securities as the index, so it provides a way for you to invest in an entire asset class without having to select particular securities. For example, if you invest in the S&amp;P 500 Index fund, you are investing in the five hundred largest corporations in the United States\u2014the asset class of large corporations.<\/p>\n<p id=\"fwk-134226-ch12_s04_s02_p03\" class=\"para editable block\">There are indexes and index funds for most asset classes. By investing in an index, you are achieving the most diversification possible for that asset class without having to make individual investments, that is, without having to make any security selection decisions. This strategy of bypassing the security selection decision is called <strong>passive management<\/strong><a class=\"footnote\" title=\"An investment strategy that does not include security selection within an asset class; the investment is expected to perform as well as the benchmark index.\" id=\"return-footnote-349-6\" href=\"#footnote-349-6\" aria-label=\"Footnote 6\"><sup class=\"footnote\">[6]<\/sup><\/a>. It also has the advantage of saving transaction costs (broker\u2019s fees) because you can invest in the entire index through only one transaction rather than the many transactions that picking investments would require.<\/p>\n<p id=\"fwk-134226-ch12_s04_s02_p04\" class=\"para editable block\">In contrast, making security selection decisions to maximize returns and minimize risks is called <strong>active management<\/strong><a class=\"footnote\" title=\"An investment strategy that includes security selection within an asset class in order to outperform the asset class benchmark.\" id=\"return-footnote-349-7\" href=\"#footnote-349-7\" aria-label=\"Footnote 7\"><sup class=\"footnote\">[7]<\/sup><\/a>. Investors who favor active management feel that the advantages of picking specific investments, after careful research and analysis, are worth the added transaction costs. Actively managed portfolios may achieve diversification based on the quality, rather than the quantity, of securities selected.<\/p>\n<p id=\"fwk-134226-ch12_s04_s02_p05\" class=\"para editable block\">Also, asset allocation can be actively managed through the strategy of <strong>market timing<\/strong><a class=\"footnote\" title=\"The practice of basing investment strategy on predictions of future market changes or on asset return forecasts.\" id=\"return-footnote-349-8\" href=\"#footnote-349-8\" aria-label=\"Footnote 8\"><sup class=\"footnote\">[8]<\/sup><\/a>\u2014shifting the asset allocation in anticipation of economic shifts or market volatility. For example, if you forecast a period of higher inflation, you would reduce allocation in fixed-rate bonds or debt instruments, because inflation erodes the value of the fixed repayments. Until the inflation passes, you would shift your allocation so that more of your portfolio is in stocks, say, and less in bonds.<\/p>\n<p id=\"fwk-134226-ch12_s04_s02_p06\" class=\"para editable block\">It is rare, however, for active investors or investment managers to achieve superior results over time. More commonly, an investment manager is unable to achieve consistently better returns within an asset class than the returns of the passively managed index.<span id=\"fwk-134226-fn12_005\" class=\"footnote\">Much research, some of it quite academic, has been done on this subject. For a succinct (and instructive) summary of the discussion, see Burton G. Malkiel, <em class=\"emphasis\">A Random Walk Down Wall Street<\/em>, 10th ed. (New York: W. W. Norton &amp; Company, Inc., 2007).<\/span><\/p>\n<div id=\"fwk-134226-ch12_s04_s02_n01\" class=\"key_takeaways editable block\">\n<div class=\"textbox key-takeaways\">\n<h3>Key Takeaways<\/h3>\n<ul id=\"fwk-134226-ch12_s04_s02_l01\" class=\"itemizedlist\">\n<li>Diversification can decrease portfolio risk through choosing investments with different risk characteristics and exposures.<\/li>\n<li>\n<p class=\"para\">A portfolio strategy involves<\/p>\n<ul id=\"fwk-134226-ch12_s04_s02_l02\" class=\"itemizedlist\">\n<li>capital allocation decisions,<\/li>\n<li>asset allocation decisions,<\/li>\n<li>security selection decisions.<\/li>\n<\/ul>\n<\/li>\n<li>Active management is a portfolio strategy including security selection decisions and market timing.<\/li>\n<li>Passive management is a portfolio strategy omitting security selection decisions and relying on index funds to represent asset classes, while maintaining a long-term asset allocation.<\/li>\n<\/ul>\n<\/div>\n<\/div>\n<div id=\"fwk-134226-ch12_s04_s02_n02\" class=\"exercises editable block\">\n<h3 class=\"title\">Exercises<\/h3>\n<ol id=\"fwk-134226-ch12_s04_s02_l03\" class=\"orderedlist\">\n<li>What is the meaning of the expressions \u201cdon\u2019t count your chickens before they hatch\u201d and \u201cdon\u2019t put all your eggs in one basket\u201d? How do these expressions relate to the challenge of reducing exposure to investment risks and building a high-performance investment portfolio? View ING\u2019s presentation and graph on diversification and listen to the audio at <a class=\"link\" href=\"http:\/\/www.ingdelivers.com\/pointers\/diversification\" target=\"_blank\" rel=\"noopener\">http:\/\/www.ingdelivers.com\/pointers\/diversification<\/a>. In the example, how does diversification lower risk? Which business sectors would you choose to invest in for a diversified portfolio?<\/li>\n<li>Draft a provisional portfolio strategy. In My Notes or your personal finance journal, describe your capital allocation decisions. Then identify the asset classes you are thinking of investing in. Describe how you might allocate assets to diversify your portfolio. Draw a pie chart showing your asset allocation. Draw another pie chart to show how life cycle investing might affect your asset allocation decisions in the future. How might you use the strategy of market timing in changing your asset allocation decisions? Next, outline the steps you would take to select specific securities. How would you know which stocks, bonds, or funds to invest in? How are index funds useful as an alternative to security selection? What are the advantages and disadvantages of investing in an index fund such as the Dow Jones Industrial Average? (Go to <a class=\"link\" href=\"http:\/\/money.cnn.com\/data\/markets\/dow\/\" target=\"_blank\" rel=\"noopener\">http:\/\/money.cnn.com\/data\/markets\/dow\/<\/a> to find out.)<\/li>\n<li>Do you favor an active or a passive investment management strategy? Why? Identify all the pros and cons of these investment strategies and debate them with classmates. What factors favor an active approach? What factors favor a passive approach? Which strategy might prove more beneficial for first-time investors?<\/li>\n<li>View the online video blog \u201c3 Keys to Investing\u201d at <a class=\"link\" href=\"http:\/\/www.allbusiness.com\/personal-finance\/4968227-1.html\" target=\"_blank\" rel=\"noopener\">http:\/\/www.allbusiness.com\/personal-finance\/4968227-1.html<\/a>. What advice does the speaker, Miranda Marquit (October 26, 2007), have for novice investors? According to this source, what are the three keys to successful investing?<\/li>\n<\/ol>\n<\/div>\n<\/div>\n\n\t\t\t <section class=\"citations-section\" role=\"contentinfo\">\n\t\t\t <h3>Candela Citations<\/h3>\n\t\t\t\t\t <div>\n\t\t\t\t\t\t <div id=\"citation-list-349\">\n\t\t\t\t\t\t\t <div class=\"licensing\"><div class=\"license-attribution-dropdown-subheading\">CC licensed content, Shared previously<\/div><ul class=\"citation-list\"><li>Personal Finance. <strong>Provided by<\/strong>: Saylor Academy. <strong>Located at<\/strong>: <a target=\"_blank\" href=\"https:\/\/saylordotorg.github.io\/text_personal-finance\">https:\/\/saylordotorg.github.io\/text_personal-finance<\/a>. <strong>License<\/strong>: <em><a target=\"_blank\" rel=\"license\" href=\"https:\/\/creativecommons.org\/licenses\/by-nc-sa\/4.0\/\">CC BY-NC-SA: Attribution-NonCommercial-ShareAlike<\/a><\/em><\/li><\/ul><\/div>\n\t\t\t\t\t\t <\/div>\n\t\t\t\t\t <\/div>\n\t\t\t <\/section><hr class=\"before-footnotes clear\" \/><div class=\"footnotes\"><ol><li id=\"footnote-349-1\">A strategy of diversifying a portfolio between risky and riskless assets. <a href=\"#return-footnote-349-1\" class=\"return-footnote\" aria-label=\"Return to footnote 1\">&crarr;<\/a><\/li><li id=\"footnote-349-2\">The strategy of achieving portfolio diversification by investing in different asset classes. <a href=\"#return-footnote-349-2\" class=\"return-footnote\" aria-label=\"Return to footnote 2\">&crarr;<\/a><\/li><li id=\"footnote-349-3\">An investment strategy in which asset allocation is based on the investor\u2019s age or stage of life. <a href=\"#return-footnote-349-3\" class=\"return-footnote\" aria-label=\"Return to footnote 3\">&crarr;<\/a><\/li><li id=\"footnote-349-4\">The process of choosing individual securities to be included in the portfolio. <a href=\"#return-footnote-349-4\" class=\"return-footnote\" aria-label=\"Return to footnote 4\">&crarr;<\/a><\/li><li id=\"footnote-349-5\">A standard, often an index of securities, representing an industry or asset class and used as an indicator of growth potential or as a basis of comparison for similar of disparate industries or assets. <a href=\"#return-footnote-349-5\" class=\"return-footnote\" aria-label=\"Return to footnote 5\">&crarr;<\/a><\/li><li id=\"footnote-349-6\">An investment strategy that does not include security selection within an asset class; the investment is expected to perform as well as the benchmark index. <a href=\"#return-footnote-349-6\" class=\"return-footnote\" aria-label=\"Return to footnote 6\">&crarr;<\/a><\/li><li id=\"footnote-349-7\">An investment strategy that includes security selection within an asset class in order to outperform the asset class benchmark. <a href=\"#return-footnote-349-7\" class=\"return-footnote\" aria-label=\"Return to footnote 7\">&crarr;<\/a><\/li><li id=\"footnote-349-8\">The practice of basing investment strategy on predictions of future market changes or on asset return forecasts. <a href=\"#return-footnote-349-8\" class=\"return-footnote\" aria-label=\"Return to footnote 8\">&crarr;<\/a><\/li><\/ol><\/div>","protected":false},"author":44985,"menu_order":4,"template":"","meta":{"_candela_citation":"[{\"type\":\"cc\",\"description\":\"Personal Finance\",\"author\":\"\",\"organization\":\"Saylor Academy\",\"url\":\"https:\/\/saylordotorg.github.io\/text_personal-finance\",\"project\":\"\",\"license\":\"cc-by-nc-sa\",\"license_terms\":\"\"}]","CANDELA_OUTCOMES_GUID":"","pb_show_title":"on","pb_short_title":"","pb_subtitle":"","pb_authors":[],"pb_section_license":""},"chapter-type":[],"contributor":[],"license":[],"class_list":["post-349","chapter","type-chapter","status-publish","hentry"],"part":324,"_links":{"self":[{"href":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/wp-json\/pressbooks\/v2\/chapters\/349","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/wp-json\/pressbooks\/v2\/chapters"}],"about":[{"href":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/wp-json\/wp\/v2\/types\/chapter"}],"author":[{"embeddable":true,"href":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/wp-json\/wp\/v2\/users\/44985"}],"version-history":[{"count":2,"href":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/wp-json\/pressbooks\/v2\/chapters\/349\/revisions"}],"predecessor-version":[{"id":582,"href":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/wp-json\/pressbooks\/v2\/chapters\/349\/revisions\/582"}],"part":[{"href":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/wp-json\/pressbooks\/v2\/parts\/324"}],"metadata":[{"href":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/wp-json\/pressbooks\/v2\/chapters\/349\/metadata\/"}],"wp:attachment":[{"href":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/wp-json\/wp\/v2\/media?parent=349"}],"wp:term":[{"taxonomy":"chapter-type","embeddable":true,"href":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/wp-json\/pressbooks\/v2\/chapter-type?post=349"},{"taxonomy":"contributor","embeddable":true,"href":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/wp-json\/wp\/v2\/contributor?post=349"},{"taxonomy":"license","embeddable":true,"href":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/wp-json\/wp\/v2\/license?post=349"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}