Ever go to the racetrack and put all your money on one horse? If that horse loses, you lose all your money. This is exactly what you don’t want to happen when you invest your money for retirement. Experts recommend investing in a variety of ways, so if one “horse” loses, you haven’t lost everything.
The strategy of distributing your investments among several types of investment categories is known as asset allocation. The most common asset classes are stocks, bonds, and cash, though more adventurous or wealthy investors often use other categories as well, investing in real estate, precious metals, commodity futures, corporate debt, or private equity.
Distributing your investments among and within these categories creates diversification. The goal of asset allocation and diversification is to spread your investment risk. When one type of investment is performing poorly, the hope is that others will continue to perform well, reducing your losses. The three main types of asset classes have varying degrees of risk:
- Stocks: Investors can buy individual stocks or mutual funds, which are groupings of stocks selected by an investment professional and bundled together. Studies of stock market performance have shown stocks offer the best return on investment over a long time frame. This higher return also comes with higher risk; there’s no guarantee a given stock will do well. Mutual funds mitigate the risk of investing in individual stocks, but in a general market downtown, when most stocks are suffering, these funds don’t fare much better.
- Bonds: Bonds are issued by the federal government, state and local municipalities, and corporations, usually to give the issuer money for a large project such as building a road or opening new stores. Bond investors trade some of the unpredictability of stock investing for a lower, guaranteed return and less risk.
- Cash: In investing, “cash” typically means a low-interest-bearing savings account or money market fund. Cash investments, such as savings accounts, usually yield rates too low to outstrip inflation, so most investors must take on at least some risk to make their money grow enough to afford retirement.
Within each asset class, it’s important to be diversified. In stocks, for example, you might invest part of your money in a broad mutual fund that includes the entire stock market or all the stocks in the Standard & Poor’s 500. You might also own a mutual fund invested in Asian or European stocks, in fast-growing U.S. companies, or in particular industry sectors, such as technology or energy.
The theory is that if some parts of the stock market perform poorly, others will do well. By the same token, you might buy a variety of bonds from various issuers to spread your risk of any one issuer running into trouble.
The final step in a strong, diversified investment portfolio is to annually review the results to make sure they still meet your goals. For instance, if you invest 80 percent of your money in stocks, later that part of your portfolio could swell until it represents 90 percent of all your investments. When your goal mix gets out of balance, it’s time to rebalance, or move some money around to other investments until your intended mix of stocks and other investments is restored. Without this annual review, your portfolio can become dangerously unbalanced over the years, leaving you exposed to more risk than you planned.