One of the most important aspects to consider in determining investment policy is how assets are to be allocated. The safety of diversification is important. Instead of limiting yourself to only one investment, divide your money among several different asset classes (for example, stocks, bonds, and cash equivalents). By diversifying – you can go a long way toward protecting yourself from those ups and downs, and from becoming dependent on any one sector of the market. Think of diversifying both among industries – not limiting yourself to stocks within a single industry. Mutual funds are a great way to handle diversification. A mutual fund is an investment company that invests in a variety of corporations. An investor who buys shares of a mutual fund automatically gets the benefit of diversification, without having to buy shares of many separate companies. Diversification is not just a good strategy; it is a key to successful investing.
An asset allocation plan is merely a model for how people divide their money among those three types of investments. The best way for you to invest will depend on a number of factors, including your investment objectives, how long you have to invest, your overall financial circumstances, and the amount you have to invest. Studies show that asset allocation is the biggest factor in determining your overall return; about 90% of your risk and return results from your asset allocation decision.
If ever there was a hackneyed investment cliché to remember and use again and again, it is to avoid putting all your eggs in one basket. Any investment can be considered a risk. Every investment is subject to unexpected changes. Nothing is completely safe. If you're narrowly invested in one stock or one sector, an unforeseen hit could be difficult to withstand. But if your investment eggs are spread around, in diverse baskets of different styles and characteristics, then the risk against inevitable change is reduced. "If you want to reduce portfolio volatility and avoid having your portfolio blow up," says Tom Biwer, an investment manager, "then following that old cliché about not having all your eggs in a single basket is a good idea."
Investing in a mutual fund provides diversification among stocks, because funds can hold shares of hundreds of different companies. But at the same time, mutual funds generally target a specific investment style (growth or value, large companies or small, technology or utilities). The market is cyclical. The duration, intensity and frequency of market changes are hard to predict. Some sectors of the market will do well while others falter. For example, technology stocks could do well at a time when utility stocks suffer. Small stocks might flourish while large stocks stumble. Then those sectors could flip-flop suddenly. The once-strong sector will fall and the once-poor sector will gain.
Find an investment balance that works for your long-term goals and ride out the inevitable rises and declines in the market. Consider growth funds, which are mutual funds that may have greater short-term volatility but offer the potential for higher returns in the long run. Or consider value funds, investing in companies that the manager views as undervalued. Investing in various sectors of the market is another good way to diversify. For example, if you include investments in such sectors as technology, utilities, consumer staples, capital equipment, and energy, the dips in one area might be offset by increases in another. And consider bond funds as another way to help soften the blows of a tumultuous or rickety market. Bond funds are usually more conservative, but they can be a good tool to balance a portfolio and possibly protect it from serious harm. The key to diversifying is variety, done with imagination, reason and commitment to long-term goals.
"Don't put all your eggs in one basket." It's good advice. When it comes to investing, diversification – putting your money into a variety of investments that have different return potentials and risk levels – means not putting all your eggs into one investment basket. Since market cycles vary, diversification may allow you to offset possible losses in one investment type with potential gains in another and, as a result, may help you reduce your overall exposure to risk. To illustrate how asset allocation can work for you, here are model portfolios with their particular risk and return levels. Keep in mind, these are for illustrative purposes only.
Stocks: 20%, Bonds: 40%, Cash: 40% (May be appropriate who need stability, income, and a little growth) Return potential: Least
Stocks: 60%, Bonds: 25%, Cash: 15%(May be appropriate who seek to balance moderate growth potential with lower-volatility investments) Return potential: Moderate
Stocks: 80%, Bonds: 15%, Cash: 5%(May be appropriate who want to temper exposure to stocks with less volatile securities) Return potential: High
Stocks: 90%, Bonds: 5%, Cash: 5% (May be appropriate who are willing to assume short-term volatility to pursue maximum growth over time) Return potential: Highest
The more aggressive approaches are generally more appropriate for investors who can "afford" the greater risks involved, either because they have sufficient assets to weather short-term volatility, or because they have a long time horizon that allows them to look past occasional downturns. When comparing asset allocation strategies to your personal financial situation, you should consider your time frame and all of your personal savings and investments in addition to your retirement assets and risk tolerance level.