Ever wonder why Mom and Pop stores sell wildly unrelated products side by side, like umbrellas and sunglasses, or Halloween candy and screwdrivers? Customers probably would never buy these items on the same shopping trip, right?
That's exactly the point. By diversifying their product offerings, vendors reduce the risk of losing sales on any given day, since people don't usually buy umbrellas on sunny days or sunglasses when it rains.
The same diversification principle also applies in the investment world, where it's referred to as asset allocation. By spreading your assets across different investment classes (stock mutual funds, bonds, money market securities, real estate, cash, etc.), if one category tanks temporarily you may be at least partially protected by others.
You must weigh several factors when determining how best to allocate your assets:
Risk tolerance. This refers to your appetite for risking the loss of some or all of your original investment in exchange for greater potential rewards. Although higher-risk investments (like stocks) are potentially more profitable over the long haul, they're also at greater risk for short-term losses. Ask yourself, would you lose sleep investing in funds that might lose money or fluctuate wildly in value for several years; or will you comfortably risk temporary losses in exchange for potentially greater returns?
Time horizon. This is the expected length of time you'll be investing for a particular financial goal. If you are decades away from retirement, you may be comfortable with riskier, more volatile investments. But if your retirement looms, or you'll soon need to tap college savings, you might not want to risk sudden downturns that could gut your balance in the short term.
Diversification within risk categories is also important. From a diversification standpoint it's not prudent to invest in only a few stocks. That's why mutual funds are so popular: They pool money from many investors and buy a broad spectrum of securities. Thus, if one company in the fund does poorly, the overall impact on your account is lessened.
Many people don't have the expertise – or time – to build a diversified investment portfolio with the proper asset mix. That's why most 401(k) plans and brokerages offer portfolios with varying risk profiles, from extremely conservative (e.g., mostly treasury bills or money market funds) to very aggressive (stock in smaller businesses or in developing countries).
Typically, each portfolio is comprised of various investments that combined reach the appropriate risk level. For example, one moderately conservative portfolio offered by Schwab consists of 50 percent interest-bearing bond funds, 40 percent stocks and 10 percent cash equivalents. Usually, the more aggressive the portfolio, the higher percentage of stocks it contains (i.e., higher risk/higher reward).
Another possibility is the so-called "targeted maturity" or lifecycle funds offered by many 401(k) plans and brokerages. With these, you choose the fund closest to your planned retirement date and the fund manager picks an appropriate investment mixture. As retirement approaches the fund is continually "rebalanced" to become more conservative.
Although convenient, this one-size-fits-all approach may not suit your individual needs; for example, you may want to invest more – or less – aggressively, or may not like some of the funds included.
These may seem like complicated concepts, but the Security and Exchange Commission's publication, "Beginner's Guide to Asset Allocation, Diversification and Rebalancing," does a good job explaining them (www.sec.gov).
[Jason Alderman directs Visa's financial education programs. To Follow Jason Alderman on Twitter: www.twitter.com/PracticalMoney.]