By Jason Alderman
Unless you raise chickens, the literal meaning of “Don’t put all your eggs in one basket” probably doesn’t apply. But we all know what the phrase implies: Don’t deposit all your money in one investment vehicle or you may risk losing it all. Think about employees who invested their entire 401(k) balances in company stock, then lost everything when the company folded (think Enron).
So how do you make sure your money is properly diversified? Many financial experts advise using asset allocation, a financial strategy that seeks to balance risk and return by dividing your assets among different investment classes such as stocks, bonds and money market securities.
The riskier the investment, the greater its potential for financial reward over the long haul. However, riskier investments have greater short-term loss potential – just consider how the stock market got pounded in 2008.
One challenge with asset allocation is determining your appetite for risk. Would you lose sleep investing in a fund that might potentially lose money, or are you willing to risk temporary losses for the possibility your account may grow faster?
Age also plays a role: The closer retirement looms, the less time your investments have to recover from a downturn before you need them. On the other hand, if retirement is 20 years away, you’ve got plenty of time to recover from market blips.
Diversification within risk categories is also important. Clearly it’s not prudent to invest in only a few stocks. That’s why mutual funds are so popular: They pool money from many investors and buy a broad spectrum of securities. Thus, if one company in the fund goes bankrupt, the overall impact is lessened.
Many folks don’t have the expertise – or time – to build a diversified investment portfolio with the proper asset mix. That’s why most 401(k) plans and brokerages like Schwab and Fidelity offer portfolios with varying risk profiles, from extremely conservative (e.g., mostly treasury bills or money market funds) to very aggressive (stock in small businesses or from emerging markets in developing countries).
Typically, each portfolio is comprised of various investments that combined reach the appropriate risk level. For example, a moderately conservative portfolio might contain 55 to 60 percent bonds, 35 to 40 percent stocks and 5 to 10 percent cash equivalents. Usually, the more aggressive the portfolio, the higher percentage of stocks it contains (i.e., higher risk/higher reward).
Another possibility is the so-called “targeted maturity” (or lifecycle) funds offered by many 401(k) plans and brokerages. With these, you choose the fund closest to your planned retirement date and the fund manager picks an appropriate investment mixture. As retirement approaches the fund is continually “rebalanced” to become more conservative.
Although convenient, this one-size-fits-all approach may not suit your individual needs; for example, you may want to invest more – or less – aggressively, or may not like some of the funds included. Also, check the fund’s prospectus to ensure fees charged are competitive.
It’s wise to consult a financial planning professional when deciding the best fund mixture for your situation.
Jason Alderman directs Visa’s financial education programs. Sign up for his free monthly e-Newsletter at www.practicalmoneyskills.com/newsletter.