Spreading Your Assets Around
Allocating the assets in your portfolio is a process.
NO SCATTER SHOTS
Asset allocation doesn't mean making random investments or simply accumulating a lot of investments for the sake of owning them. In fact, it's just the opposite. Allocation is about finding the right mix of asset classes to match your goals, given your age, the amount you have to invest, and your risk tolerance. Then you'll be ready to diversify your portfolio within each asset class.
These funds and accounts offer the benefit of diversification within an asset class or sometimes across classes. Typically, an equity fund owns shares in 60 to 100 or more companies across a range of products and services, though the number does vary. A balanced fund might own 60% equities and 40% bonds, while an index fund owns all of the securities in the market index it tracks. Separate account funds similarly have a specific objective and own a range of investments within a particular asset class.
One caution is worth heeding, though. If you build a portfolio with three different large-company growth funds, you're not as diversified as you would be with one large-company fund, one small-company fund, and a fund focused on buying shares in undervalued or out-of-favor companies. Among other drawbacks to owning three funds with the same objective is that they are likely to invest in many of the same securities.
A diversified portfolio typically has a mix of stocks, bonds, and cash, including the mutual funds and variable annuity separate accounts that belong to each of the asset classes you're including.
In other words, within the universe of stocks, the portfolio would contain stock in a variety of companies, of different sizes, and in different businesses. Similarly, investments in international or multinational companies may be a good way of adding further diversification to your portfolio because they don't necessarily respond to the same economic factors as domestic companies. However, you need to be aware of currency risk and the potential for political unrest when you invest abroad.
The same range is appropriate in each of the other asset classes. Bonds are issued by different types of companies, pay different rates of interest, and have different credit quality. Some mix of those alternatives is likely to serve you better than a portfolio made up entirely of Treasury bills or mortgage-backed bonds.
After you've decided on an allocation, you'll probably have to realign your portfolio from time to time to maintain it. If your stocks do particularly well in one year, for example, your allocation may be more heavily weighed toward equities than it was originally, as the chart to the right illustrates. That means your portfolio will be potentially more volatile.
To rebalance, you can sell some stock and reinvest the money in bonds or cash, or you can add new investment money to those asset classes rather than to equities. Some mutual fund companies and variable annuity programs offer automatic rebalancing to make the task easier, though you'll pay an additional fee for that service.