Asset Allocation and Portfolio Diversification: Choosing the Right Funds for your 401k

Here we're going to cover the basics of asset allocation and portfolio diversification.

Big words, simple concepts.

Asset allocation is how much you decide to invest in different securities:

whether you put half in stocks and half in bonds; 60% in Stocks, 40% in Bonds; or if you decide to put all of your money into stocks.

No matter what percentage, you're making an asset allocation.

Portfolio diversification is asset allocation magnified. So you know you want 65% of your investments in stocks, but how will you allocate them among all the different stock and bond options available:

Example 1:

Example 1 isn't very good portfolio diversification. In the case of a weak US Stock Market or recession your retirement portfolio will take a significant hit.

Example 2:

Example 2 is even worse than Example 1. This is the story we learned from Enron employees. If your company stock tanks, your retirement will remain a dream. No recession or market crash necessary, just one company falters and you're done.

Example 3:

Example 3 is a good, if slightly risky portfolio diversification. It has a heavy emphasis on non-US securities (over a third of the portfolio is in foreign companies) which makes it riskier than a traditional, conservative investor would recommend.

But Example 3 is well hedged against any one sector or market faltering.

As you can see, portfolio diversification is a lot more focused and detailed than asset allocation. And it can be tricky.

Consider Example 3 above. Now, imagine that US Stocks fall in value by 10% and Emerging Market and Asian Stocks rise by 40%. The above portfolio would shift its emphasis and look like this:

Emerging Markets and Asia are now almost as heavily weighted as Europe, and US Stocks are actually a smaller part of the portfolio (36%) than foreign investment (39%).

Now, imagine that US Bonds rise by 10%, European Stocks fall by 7%, European & Emerging Market Bonds rise by 8%, company stock doubles and the dollar falls by 0.11%:

This is not at all atypical, so understand that diversification needs to be watched and, every six months or so, funds should be re-allocated. But you can see that, through diversification, losses are limited, because certain sectors gain back the losses.

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