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
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. The 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 asset classes is a way to reduce risk in your portfolio. For example, if stocks fall dramatically, the other asset classes will likely help mitigate your losses.
Diversification
Choosing your asset allocation is just the beginning. In order to minimize your risk, you 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 that you can better protect the wealth you've already accumulated.
In the intervening years, you will periodically tweak your asset allocation so that it changes with your situation. You will also monitor your specific holdings in each portfolio, making occasional adjustments so that you are properly diversified. The ultimate result is a portfolio that evolves with you and the current market situation, so you are prepared for whatever economic weather comes your way. However, please note that asset allocation and diversification do not assure a profit or protect against loss in declining financial markets. Please call if you'd like to discuss asset allocation and diversification in more detail.