You can knit together a diversified portfolio of investments. Putting part of your 401(k) contribution into equities, part into fixed-income investments, and perhaps part into cash is only the first step in creating your 401(k) portfolio.
Unless you have a limited choice, you’ll need to decide among investments within those classes to create a diversified portfolio. That means identifying subclasses of investments within each of these three asset classes.
For example, although a fund that buys a small-company stock and a fund that buys stock in large companies are both equity funds, they are significantly different investments. Each one exposes you to varying levels of risk, changes in value at different rates, and may prosper in different economic circumstances.
What’s diversification and how does it work?
Diversifying your retirement account assets means spreading your assets among different asset classes and investment styles. Diversification can help you manage risk, but it doesn’t guarantee a profit or prevent a loss in a falling market.
So, when small-company stocks provide more substantial returns than large-company stocks, a small-company fund is likely to give a more robust return than a large-company fund and vice versa. If you own each type of fund, you’re better positioned to benefit from a strong return on at least a portion of your portfolio, no matter which fund is providing the stronger performance at any given time. That’s the whole point of diversification: It means you’re investing in protecting your portfolio against significant losses that could result from a drop in value of a single investment category or market sector.
Diversification works because the major asset classes tend to move in opposite directions. So do the subclasses within them. For example, when investors buy stock, the stock provides a substantial return, and bond returns are likely to be weaker. And when investors get out of the stock market and buy bonds, bond returns generally strengthen when stock returns weaken.
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Similarly, there are times when overseas stocks (and the mutual funds that invest in them) provide more substantial returns than stocks in US companies. At other times, domestic stocks are on top.
If you keep money invested in various asset classes and subclasses, you can benefit in two ways. First, you’re in a position to profit from strong returns in a particular subclass. Second, those gains may help offset losses in a class or subclass slowing down.
What’s foreign diversification?
International investments, especially equities, are also an essential part of diversification. Because the world’s economies respond primarily to events and conditions in their homelands or regions, investing abroad is a way to build a broad-based portfolio. And the opportunity to invest in emerging as well as developed markets offer a further level of diversification.
While the ups and downs of investment performance are clearly recognizable, it’s almost impossible to predict when they might occur.
If you try to time the market — for example, if you wait to buy until exactly the moment you think an investment is about to take off, you run the risk of being out of the market when the price increases most. And you’ll end up paying more to invest.
While international investing provides diversification simply by raising the number of potential investment choices, it also adds diversity by spreading your investments across different regions of the world. For example, putting money into a European or Asian fund can position you to benefit from potential strength in those areas during periods when the US economy is sluggish or in recession.
Investors can benefit further from diversification by investing in foreign securities, as they are usually less closely correlated with internal ones.
In general, mutual funds provide the simplest way to invest internationally since they handle all of the currency and taxation issues that go along with buying and selling abroad. But while choosing such a fund can add diversification, it can’t insulate you from potential risks of currency fluctuation and political turmoil.
Is diversification worth it?
If you want to increase your savings and reduce your risk over the long term, diversifying or mixing your retirement investments may help you. However, there are some drawbacks as well. Firstly, it requires much more time and research if there is a set of options. It can be more expensive because buying and selling many different holdings incurs more transaction fees and brokerage commissions. In addition, it limits short-term profits and may not be suitable for your retirement goals. This means you must rebalance the portfolio to maintain a certain percentage of each asset category over time.
But, of course, diversification has many benefits. First and foremost, it reduces portfolio risk. Spreading your holdings across asset types, such as stocks, bonds, and cash, may minimize investment risk and improve your chances of achieving your retirement goals.
Another advantage is protecting against market volatility. The more a portfolio is diversified across different asset classes and strategies, the more volatility can be reduced. Diversification offers higher returns long-term. Combining investments with varying risk and reward profiles can help reduce drastic changes in price over time.
So, a diversified portfolio contains investments that are not only individually strong but also distinctly different from each other. However, it’s essential to remember that diversification does not guarantee a profit or protect against losses in a falling market.
Why does diversification matter?
Diversification doesn’t help to choose the best investment, but it helps to help protect your overall asset balance if you choose the worst one. Choosing the right combination of investments and then periodically restoring your balance and monitoring your choices can help you capture returns and protect your balance against the risk of a downturn in any asset class.
If your 401(k) plan offers just one fund in each asset class, making decisions is more straightforward than it might otherwise be. You just carry out your allocation strategy with the options you have. But you’ll want to make sure you diversify more broadly in your overall portfolio. If you have several fund choices within a single asset class, say several stock funds, look first at each fund’s investment objective. Try to avoid investing in several funds making the same type of investment.
While a fund’s name is often a helpful clue, please don’t take it at face value. Instead, look first at the fund’s prospectus for its official statement, and then check to see how the fund is classified by research companies, including Lipper Inc. and Morningstar. For example, you may find that one fund that describes itself as a small-company fund invests more in mid-sized companies than another small-company fund. Unfortunately, that could mean you’re not as diversified as you’d like to be.
How To Diversify Your 401k And Get A Better Return? by Inna Rosputnia
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