A diversified portfolio should be diversified at two levels: between asset categories and within asset categories. So in addition to allocating your investments among stocks, bonds, cash equivalents, and possibly other asset categories, you’ll also need to spread out your investments within each asset category. The key is to identify investments in segments of each asset category that may perform differently under different market conditions.
One way of diversifying your investments within an asset category is to identify and invest in a wide range of companies and industry sectors. But the stock portion of your investment portfolio won’t be diversified, for example, if you only invest in only four or five individual stocks. You’ll need at least a dozen carefully selected individual stocks to be truly diversified.
Because achieving diversification can be so challenging, some investors may find it easier to diversify within each asset category through the ownership of mutual funds rather than through individual investments from each asset category. A mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, and other financial instruments. Mutual funds make it easy for investors to own a small portion of many investments. A total stock market index fund, for example, owns stock in thousands of companies. That’s a lot of diversification for one investment!
Be aware, however, that a mutual fund investment doesn’t necessarily provide instant diversification, especially if the fund focuses on only one particular industry sector. If you invest in narrowly focused mutual funds, you may need to invest in more than one mutual fund to get the diversification you seek. Within asset categories, that may mean considering, for instance, large company stock funds as well as some small company and international stock funds. Between asset categories, that may mean considering stock funds, bond funds, and money market funds. Of course, as you add more investments to your portfolio, you’ll likely pay additional fees and expenses, which will, in turn, lower your investment returns. So you’ll need to consider these costs when deciding the best way to diversify your portfolio.
Options for One-Stop Shopping- Lifecycle Funds
To accommodate investors who prefer to use one investment to save for a particular investment goal, such as retirement, some mutual fund companies offer a product known as a “lifecycle fund.” A lifecycle fund is a diversified mutual fund that automatically shifts towards a more conservative mix of investments as it approaches a particular year in the future, known as its “target date.” A lifecycle fund investor picks a fund with the right target date based on his or her particular investment goal. The managers of the fund then make all decisions about asset allocation, diversification, and rebalancing. It’s easy to identify a lifecycle fund because its name will likely refer to its target date. For example, you might see lifecycle funds with names like “Portfolio 2015,” “Retirement Fund 2030,” or “Target 2045.”
Changing Your Asset Allocation
The most common reason for changing your asset allocation is a change in your time horizon. In other words, as you get closer to your investment goal, you’ll likely need to change your asset allocation. For example, most people investing for retirement hold less stock and more bonds and cash equivalents as they get closer to retirement age. You may also need to change your asset allocation if there is a change in your risk tolerance, financial situation, or the financial goal itself.
But savvy investors typically do not change their asset allocation based on the relative performance of asset categories – for example, increasing the proportion of stocks in one’s portfolio when the stock market is hot. Instead, that’s when they “rebalance” their portfolios.