Portfolio Strategy

Modern Portfolio Theory: asset allocation, diversification and rebalancing

Asset allocation, diversification and rebalancing are all part of a sound portfolio strategy that is built around the time-tested economic concepts of Modern Portfolio Theory. By using these financial concepts, you get an easy-to-follow investment plan tailored to your needs.

Modern Portfolio Theory: Finding an optimal portfolio

If you're going to invest your hard-earned money, you naturally want to minimize your risks, while maximizing your potential returns. This is the basis of Modern Portfolio Theory (MPT), the foundation of our investment strategy. Developed by Nobel Laureate Harry Markowitz, and refined by other noted economists over the years, MPT suggests that you can limit the volatility in your portfolio, while improving its performance, by spreading the risk among different types of securities that don't always behave the same.

It is a principle of investing that the higher the risk, the higher the potential return and conversely, the lower the risk, the lower the return. According to MPT, a portfolio (a combination of individual investments) exhibits risk and return characteristics based on its composition and the way those components correlate with each other. For each level of risk, there is an "optimal" asset allocation that is designed to produce the best balance of risk versus return. An optimal portfolio will provide neither the highest returns, nor the lowest risk of all possible portfolio combinations — it will attempt to balance the lowest risk for a given level of return and the greatest return for an acceptable level of risk. This meeting point of each level of risk and reward, where the optimal portfolios reside, is called the "Efficient Frontier."

Efficient Frontier of Optimal Portfolios

Your goal should be to maximize your return for the amount of risk that you are comfortable accepting. To help you do that, you need a properly allocated and diversified portfolio.

Asset Allocation: Creating the mix

If you're asking yourself, "How should I invest to create an optimal portfolio?" an asset allocation process may be the answer. If you choose Amerivest, you'll receive an asset allocation recommendation based on your personal situation — goal, time frame, risk tolerance and amount invested. This plan will clearly show you which asset classes to invest in, such as stocks, bonds and cash — and how much to invest in each class.

If you select a TDX Independence ETF or an Amerivest Target Date Investment Portfolio, you'll receive a fund or portfolio designed with a specific target date in mind. Both take advantage of the "lifecycle" investing concept, where a single investment is designed to change asset allocation over time. Independence ETFs are individual investment products traded intraday on the New York Stock Exchange. As with all ETFs, the funds are a collection of underlying securities. And like most, they are designed to track an index. In this case, the indexes have been created to reflect a portfolio of investments that can be used for lifecycle investing with respect to five different target dates. Amerivest Target Date Investment Portfolios are composed of ETFs representing specific asset classes.

There's an optimal asset allocation for each situation Since your portfolio seeks to maximize potential returns while minimizing risk, it's important that your investments are allocated over a variety of asset classes, such as equities, fixed income and cash. The reason is that each asset class performs differently over time due to its unique balance of risk and reward. Traditionally, stocks have a higher rate of return, but also a higher risk. Bonds and cash both are usually lower-risk investments, which produce more modest returns.

Both Independence ETFs and Amerivest Target Date Investment Portfolios initially have an allocation model that accepts greater risk while actively seeking capital appreciation. As the target date approaches, allocations shift to accept less risk and seek to preserve the value of your portfolio.

Different asset classes perform differently over time

By allowing you to spread your investment risk over different asset classes, asset allocation helps lead you toward the reward you want, while mitigating your risk.

Diversification: Stabilizing your investments

So now you know where your money should go. But what specific securities should you invest in? This is where diversification comes in — spreading each asset class investment over different securities within that class. This seeks to reduce your portfolio's volatility and improve its stability.

Amerivest uses ETFs in an effort to achieve diversification within a portfolio. The ETFs are evaluated using an objective process that includes various quantitative and qualitative assessments. Eligible ETFs are chosen based on which asset class they belong to. Then they are analyzed for other data, such as historical performance, expense ratio, tracking error and liquidity. Past performance does not guarantee future results.

Independence ETFs are constructed of underlying securities from three primary asset classes: international equity securities, domestic equity securities and fixed-income securities (including cash and cash equivalents).

Before investing in an ETF, carefully consider the investment objectives, risks, charges and expenses. For a prospectus containing this and other important information, contact a Client Services representative at 800-669-3900. Please read the prospectus carefully before investing.

Rebalancing: Keeping you on track

Studies have shown that periodic rebalancing can significantly lower the overall risk in a portfolio. Establishing your portfolio is only the beginning of your journey toward your financial goal. Over time, the various investments in your portfolio may alter in value, due to changing market conditions. This can lead your portfolio's asset allocation mix to drift out of balance. In order to ensure that your portfolio is working as it was designed to work — and is leading you toward your financial goal — it's important to rebalance it periodically.

Rebalancing usually involves selling portions of your investments that have increased in value significantly. These funds can then be used to purchase underperforming portfolio assets, in order to bring your portfolio back to its original asset allocation mix.

Amerivest makes available the Auto-Rebalance feature, helping you to avoid two pitfalls of doing it yourself: forgetting to do it regularly and trying to time the market. Amerivest can help you follow through on the counterintuitive approach of selling winners and buying out-of-favor assets. With an Amerivest Target Date Investment Portfolio, you will also be able to monitor the drift of your portfolio away from the target allocations, and be able to rebalance, either manually or automatically through the Auto-Rebalance feature. In addition, Amerivest will provide recommendations to reallocate between asset classes periodically as the target date approaches to keep your portfolio headed in the right direction. If you select an Independence ETF, the fund management will reconfigure the portfolio of each fund, typically quarterly, to reflect the quarterly reconfiguration of the underlying index.