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 in order to create a diversified portfolio. That means identifying subclasses of investments within each of these three asset classes.

For example, even though a fund that buys 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 different levels of risk, changes in value at different rates, and may prosper in different economic circumstances.

Understanding the diversification

So when small-company stocks are providing stronger returns than large-company stocks, a small-company fund is likely to provide a stronger 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 to protect your portfolio against major losses that could result from a drop in value of a single investment category or market sector.

In other words, 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.

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The seesaw principle

Diversification works because the major asset classes tend to move in opposite directions. So do the subclasses within them. For example, when investors are buying stock, stock provides a strong 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 and stock returns weaken. Similarly, there are times when overseas stocks (and the mutual funds that invest in them) provide stronger returns than stocks in US companies. At other times, domestic stocks are on top.

If you keep money invested in a variety of 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 that’s slowing down.

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.

Using variety wisely

If your 401(k) plan offers just one fund in each asset class, making decisions is simpler 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 investment in several funds all making the same type of investment.

While a fund’s name is often a useful clue, don’t take it at face value. 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. 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. That could mean you’re not as diversified as you’d like to be.


Looking further afield

International investments, especially equities, are also an important 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 offers a further level of diversification.

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 fund or an Asian fund can position you to benefit from potential strength in those areas during periods when the US economy is sluggish or in recession.

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.

How To Diversify Your 401k And Get A Better Return? by Inna Rosputnia

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