Asset allocation and portfolio diversification are words often bandied about by investment advisors and financial planners. But what exactly does it mean for the ordinary investor and why do you need it? Simply put, asset allocation is how you distribute your investments among the different types of investment vehicles such as stocks, bonds and mutual funds. And portfolio diversification is simply taking asset allocation one step further, by mapping out further diversity within a specific asset class, such as investing in both U.S. stocks and emerging market stocks.
You need to do this to minimize the risk of too much exposure to one asset class or product. Every sector has problems periodically. For example, the current real estate and financials crisis has not yet significantly affected the general economy or overseas markets. Thus, an investor who had a diversified portfolio with REITs, company stocks, U.S. bonds and emerging market investments would likely have a cushion and a safety net.
Moving on to asset allocation strategies for qualified retirement plans like a 401(k), what are the options, and what is the best way to ensure a sufficient diversity of financial products without sacrificing performance?
The first thing to consider is your needs, and the costs to fulfill those needs, after retirement. Once you have a ballpark needs figure compared with resources on hand, you can figure out what kind of return rates you need. Once you have a return rate, you need to work out a mix of asset classes which will provide you with this return rate. The trick here is to include as much of a safe asset class, such as bonds, as possible. Start the calculations from the lower end, where you get less than what you need, but with reduced risk. Increase the risky asset classes in small increments, while reducing the safe ones, until you end up at the right rate of return, after adding up the returns from al asset classes.
A general rule of thumb is that the further away from retirement you are, the more risks you can afford to take. As you move closer to retirement, it is better to move more and more assets into safer areas. Thus, for people aged 50 or below, an aggressive combination of 80% private equity, alternative investments and growth stocks is recommended, while for those close to retirement, a majority portion of the total investment should be in a safe class such as U.S. treasury bonds.
This may sound a bit complicated, but there are easier ways, such as charts and tools and calculators to help you perform 401(k) asset allocations. Please note that employers have the right to offer, or decline, specific asset classes and sub-accounts to employee 401(k) plans. You are advised to consult your company’s plan advisor or manager and study the historical performance data for the plan, as a whole.