Recently, a client was losing sleep worrying about the Market and his retirement plan investments. To put his mind at ease, we talked about 3 strategies designed to limit risk: Asset Allocation, Diversification, Portfolio Rebalancing.
Here’s an overview of what we discussed. Maybe it will help you as well.
1. Asset Allocation
Asset allocation is one approach that could help you manage investment risk. But it does not guarantee against investment loss. The idea behind asset allocation is to potentially reduce the overall risk of a portfolio by offsetting any losses in one asset class with gains in another. Investors might divide their money among different asset classes such as: stocks, bonds and cash alternatives like money market accounts.
Other considerations might be included, but often these 2 factors can be part of asset allocation decisions:
- Time: Investors with plenty of time before retirement might be more comfortable with investments that offer higher potential returns but carry higher risk. An investor that’s nearing retirement age might consider market volatility more closely when evaluating investment choices.
- Risk tolerance: Investors with a high-risk tolerance might feel comfortable with greater market volatility in the pursuit of potential returns. An investor that’s closer to retirement age could have a low-risk tolerance and be in favor of investments that might limit volatility.
This is another investment principle designed to manage risk. It does not guarantee against a loss. Diversification attempts to identify investments that may perform differently under various market conditions.
A portfolio can be diversified between asset classes, such as: stocks, bonds, and cash alternatives. Also, a portfolio can be diversified within asset classes such as a diverse basket of stocks.
Example: Let’s say a stock portfolio includes an airline, a railroad company, and a package delivery company. Although this portfolio has spread its risk among 3 companies, it may not be considered well diversified since all the stocks are connected to the transportation sector. A portfolio that includes a health care provider, a wireless telecommunications company and a chemical manufacturer may be considered more diversified.
3. Portfolio Rebalancing
Rebalancing is the process of restoring a portfolio to its original risk profile, possibly the way a retirement plan was originally created. If all the investments selected had the same return, that balance would remain steady for a period of time. But if the investments had varying returns, over time the portfolio may look different than the original asset allocation had intended.
Generally speaking portfolios can be rebalanced two ways:
- Add new money to those assets or to asset classes that have fallen. (This does not guarantee against a loss)
- Sell enough of the “winners” to buy more underperforming assets. (Also, this doesn’t guarantee against a loss)
Some investors may set a time each year to review a portfolio and determine if adjustments are appropriate for the investments in a retirement plan.
Asset Allocation vs. Diversification
Asset allocation and diversification may seem the same, but they are different. An investor may have excellent diversification but weak asset allocation or vice versa.
Asset allocation refers to investing in different categories of investments, called asset classes. Generally, investors may choose from stocks, bonds, cash, commodities and real estate.
Diversification is the process of balancing these classes so they potentially offset one another during changing market conditions.
Example: Suppose an investor buys one single stock, one bond, one commodity - this is an example of good allocation across the asset classes. However, the diversification is weak.... Now suppose the investor doesn’t choose just one stock, but several stocks divided among small-capitalization, mid-cap and large-cap. And instead of one bond, the investor may hold short-term, intermediate and long-term corporate bonds, plus Treasuries. The same is true for commodities if the investor could hold not just gold, but silver, copper, etc.
It’s natural to worry about retirement plans when we experience Market volatility. But maybe you can put your mind at ease and get better sleep if you consider ways to limit investor risk. Please remember Asset Allocation, Diversification and Portfolio Rebalancing are strategies designed to limit risk, but they do not guarantee against loss.
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