Brushing up on the basics of asset allocation and diversification might help you make informed retirement planning decisions.
Asset classes vary in risk and reward
First, let’s review the three basic asset classes: stocks, bonds and cash or stable value.
These are shares of ownership in a public company. Stocks carry greater risks than bonds or cash/stable value options. Historically, stocks have offered the greatest potential for long-term growth.
Bonds are IOUs issued by a corporation, the government, or a government agency. The issuer promises to pay bondholders the principal plus a stated rate of interest when the bond matures. Generally, bonds offer moderate risk and lower returns than stocks.
Cash or stable value
Investments in this asset class seek to preserve principal, provide consistent returns, and remain liquid. They offer low investment risk and lower returns.
Diversifying helps balance your portfolio
When you diversify, you invest in a variety of asset classes to help balance risk and return. A simple example is an account that holds a stock fund, a bond fund and a cash fund. If one part of your portfolio is doing well and another is losing value, the gains may help offset the losses. It’s also possible to diversify within an asset class. For example, you may choose a large-cap stock fund and a small-cap stock fund.
Asset allocation works with diversification
Asset allocation allows you to divide your investments among asset classes. You determine your asset allocation by considering your risk tolerance and the amount of time you have until you retire—your “time horizon.” A more aggressive portfolio with a higher level of risk exposure includes more stocks, while a more conservative portfolio includes more bonds or cash/stable value.
Differences in returns among asset classes may cause your asset allocation to shift over time, so you should review your account annually and adjust it, if necessary. Adjusting your asset allocation back to your desired mix is called rebalancing.
Please note that diversification and asset allocation cannot guarantee a profit or protect against investment loss.
Review your investments
Now that you’ve brushed up on asset allocation and diversification, look at your retirement account investment mix and make sure it aligns with your goals.