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Actions Understand Diversification Strategy
Key Takeaways
- It's like life: planning, commitment, discipline.
- Target-date funds can take you from overwhelmed to on target.
- Bad may not be so bad — if you rebalance.
Diversification — spreading your money among different types of investments to lower your overall risk and potentially increase the value of your portfolio — can be intimidating. So before you employ this important strategy with your retirement savings, it pays to get familiar with diversification basics. But once you understand the fundamentals, it’s time to take action. Doing so can help ensure that you have enough money to support your lifestyle and financial needs in retirement.
Developing financial goals is no different than any other large life commitment: it takes strategic planning up front and disciplined execution throughout. Once you’ve chosen some investments, you’ll want to make sure you monitor and rebalance your assets periodically in order to keep your original strategy in play, particularly if your circumstances change.
How you can diversify within your investment account
How you diversify can depend in part on your age. If you place most of your retirement savings in equities (stock investments), you may be able to take advantage of downturns by buying stocks at lower prices. Some people choose to go heavy on stocks when they’re in their 20s and 30s, giving their portfolio time to weather a downturn (or two) in the stock market.
Because bonds are generally considered less risky investments than stocks, less aggressive investors might focus there instead. As we age, some people switch to bonds and even home ownership as a way of avoiding stock market risks.
In order to diversify your stock portfolio within your retirement account, you might consider index funds. These aim to match parts of the market and let you invest in companies that do enormous amounts of business. For example, an S&P 500 index fund tracks the movement of the 500 largest U.S. stocks. Along with this large-cap fund (shares of companies with market capitalizations, or overall stock values, of $10 billion or more), you can select mid- (market caps of $2 billion to $10 billion) or small-cap ($300 million to $2 billion) funds, which may help protect you if the larger companies perform poorly. And don’t forget an international index fund. Many 401(k), 403(b) or other retirement accounts typically offer similar options.
Additional diversification possibilities exist beyond index funds. You can also work with mutual funds, exchange-traded funds (ETFs) and real estate investment trusts (REITs), among others.
The idea is to try to protect your overall portfolio, so the entire plan isn’t destroyed by one failing investment.
Many workplace retirement savings plans and IRAs also provide access to “target-date” funds. These are a somewhat automated option, which will change your asset allocation (how much of your money you devote to different types of investments) as you age and the target date nears. This reduces your exposure to riskier equity investments and increases exposure to fixed-income (typically bond) investments. It can be a good choice for people who feel overwhelmed by — or simply don’t want to take the time to — manage their asset allocation manually. (Even so, the value of a target-date funds is never guaranteed, including at or after its target date.)
Different funds offer potential advantages but also have different types of risks, and some have more risk than others. Since there are no guarantees, it’s important that you review a fund’s objectives and associated risks before you invest to make sure it’s appropriate for your goals and risk tolerance.
It’s OK if some of your assets perform poorly
Not all of your investments will perform well all the time. The idea is to try to protect your overall portfolio so your entire plan isn’t destroyed by one failing investment.
When you diversify, your portfolio likely won’t grow as much as the best-performing part of the market each year — but it also shouldn’t fall as far as the worst-performing asset. The goal is to help mitigate risk over time, rather than chase the highest returns each year.
Many financial professionals suggest rebalancing your portfolio periodically to make sure your investment allocation stays in-sync with your strategy. For example, if you began investing with a 50% investment stake in stocks and 50% in bonds, but investment performance gradually caused your stocks to comprise 60% of your portfolio (with bonds shifting to 40%), you can look to rebalance by selling enough stocks and buying enough bonds to return you to your 50/50 target allocation.
What you can do next
Diversifying your investments across — and within — the major asset classes can be key to managing your portfolio's risk (and your stress level) as you pursue your financial goals. In general, try to make sure your diversification strategy dovetails with your "time horizon" and risk tolerance. Please consult your tax and legal advisors regarding your circumstances.
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