Asset Allocation and Diversification
At least annually, you should thoroughly review your 401(k) plan. Some items to consider include: So, it’s time to start selecting investments for your retirement account. You sit down at your desk, start looking over the list of investment options, and are quickly overwhelmed. How do you build your retirement portfolio (or any other investment portfolio)? What’s right for you? The answer to those questions lies in two essential investing concepts: asset allocation and diversification.
Asset allocation sounds complicated, but it’s actually a fairly simple concept. It involves selecting a variety of different types or categories of investments — called asset classes — for your portfolio as a way to hedge against risk. Asset classes the average investor is most likely to encounter include cash equivalents, stocks, and bonds. Other asset classes include commodities, real estate, and other investment alternatives. Why invest in different asset classes? Because asset classes are affected differently by economic events and market factors, investing in a variety of them is a way to reduce risk in your portfolio. For example, if stocks fall dramatically, the other asset classes in your portfolio will likely help mitigate your losses.
Choosing your asset allocation is just the beginning. In order to minimize risk, you'll also need to think about diversification. But if you just built a portfolio out of several different asset classes (say, stocks, cash and bonds), aren’t you already diversified? Not necessarily. In addition to diversifying among asset classes, you also need to diversify within asset classes. Diversification is simply another way of saying, “Don’t put all your eggs in one basket.” If 60% of your portfolio is in stocks, 30% in bonds, and 10% in cash equivalents, you are diversified among asset classes. But if you only own two or three different stocks, you’re not diversified within that asset class. If one of those stocks plummets in value, your portfolio could take a big hit. Diversification may sound fairly simple, but it can be more complicated than many realize. For example, you may think you’re well diversified by investing in eight or nine different stocks. But if each of those stocks is in the same industry, they’ll each have roughly the same performance. To better diversify, you might want to select nine stocks in nine different industries. Another big diversification error people make is investing too much in their employer’s stock. No matter how confident you feel about the future of your company, it’s rarely smart to place too much of your assets there — if the business goes under, you could be out of a job and much of your savings.
Asset Allocation and Diversification in Practice
How do you determine the right asset allocation or diversification for your portfolio? It depends on your investment goals and time frame. If you are young and investing for retirement, you can afford to have a significant portion of your assets in equities, with the goal of maximizing your investment return. As your retirement date nears, you’ll likely want to shift to a more conservative portfolio with a smaller allocation to stocks, so you can better protect the wealth. In the intervening years, you should periodically tweak your asset allocation so it changes with your situation. You should also monitor your specific holdings in each portfolio, making occasional adjustments so you are properly diversified. The ultimate result is a portfolio that evolves with you and the current market situation.
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This newsletter was prepared by Integrated Concepts Group, Inc. The opinions expressed in this newsletter are for general information only and are not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. The views expressed are those of the author and may not necessarily reflect those held by PlanMember Securities Corporation. Material presented is believed to be from a reliable sources and PSEC makes no representation as to it accuracy or completeness.