You’ve probably heard of the terms “asset allocation” and “diversification.” They sound complicated, but really, the concepts are quite simple.
Asset allocation is the process of dividing the money in your investment portfolio among the three main asset classes: stocks, bonds and cash. Diversification takes that process one step further. When you diversify your portfolio, you select different types of investments within an asset class. For example, the bond portion of your portfolio might include corporate, municipal and U.S. Treasury bonds, while the stock portion might include stocks of companies based in and outside of the U.S.
But why diversify? Over the long term, diversification can help you decrease risk and increase returns. Keep in mind that diversification does not ensure a profit or protect against market loss.
Of course, there are many different ways to diversify a portfolio. Among them are:
The amount of time for which you’ll be investing plays a big role in portfolio diversification. If you have 30 or 40 years to ride out market highs and lows, you may be willing to invest primarily in stocks; stocks come with greater potential risk than bonds and cash, but also greater potential return over the long term. On the other hand, if you’ll be tapping into your savings in the next five or 10 years, you may be more comfortable exchanging lower potential returns for lower potential risk and investing a greater portion of your portfolio in bonds and cash.
Your tolerance for investment risk—that is, your comfort level with fluctuations in the value of your portfolio—is an equally important factor in diversification decisions. If you have a high risk tolerance, you probably invest mostly in stocks and long-term bonds. But if you have a low risk tolerance, you may be more comfortable with short-term bonds and cash investments.
Investment style adds yet another layer of diversification to your portfolio. “Growth” and “value” are examples of stock investment styles. Growth investors seek companies that offer strong earnings growth while value investors seek stocks that appear to be undervalued in the marketplace, but may provide a superior return. Including more than one investment style in your portfolio helps ensure that its overall performance isn’t dependent on the performance of just one type of investment.
Economic, political and other factors can have different effects on markets around the world. By choosing both domestic and international investments, you lower the risk that financial instability in one part of the world will affect your entire portfolio.
Even if you understand the concepts of asset allocation and diversification, you may still want a professional opinion on the best way to diversify your portfolio. Contact your financial professional.
Neither asset allocation nor diversification ensure a profit or protect against market loss.
Our FutureFIT® approach lets you personalize your retirement experience – that’s why we call it Freedom. Individually Tailored.® Give us a call today and learn how we can help you take the next step toward the future you envision! 1-888-569-7055.