Constructing an investment portfolio involves more than simply choosing assets; it requires thoughtful decisions about how those assets work together. Diversification is the practice of spreading investments across various assets, sectors, or geographic regions to reduce risk. The principle works because different assets do not move in perfect lockstep, so losses in one area can be cushioned by gains or stability in another. The familiar saying "don't put all your eggs in one basket" captures the essence of this idea.
Closely related is asset allocation, which refers to how a portfolio is divided among different asset classes such as stocks, bonds, and cash. Asset allocation is typically driven by an investor's risk tolerance, financial goals, and time horizon, and research suggests it accounts for the majority of a portfolio's long-term returns and risk levels. A common model is the 60/40 split between stocks and bonds, though the right mix varies by individual circumstance.
Once an allocation is set, it does not remain static on its own. Over time, market movements will cause certain assets to grow faster than others, drifting the portfolio away from its intended targets. Portfolio rebalancing restores the target allocation by selling overperforming assets and buying underperformers, often done annually or whenever the drift exceeds roughly 5 to 10 percent. This disciplined practice effectively enforces a "sell high, buy low" approach and controls risk drift. Investors should also consider liquidity, or how quickly an asset can be converted to cash without affecting its price. Cash is the most liquid asset, while real estate is among the least. Holding illiquid assets carries the risk of being forced to sell at unfavorable times during downturns.