You hear it from the day you start your first job: Save up for retirement, and start now. It is great advice, and you should follow it. If your company has a 401(k) or similar plan in place, great. If they match employee contributions, even better. A company-sponsored plan is a great place to start. However, if you want to be in control of your money, you will want to make some investments on your own. It is not always clear where to begin, so keep two fundamental ideas in mind as you start to plan: asset allocation and diversification.
Two Different Approaches to Asset Allocation
The term asset allocation refers to the way in which your money is invested. Your assets are the investments you own, and their allocation is how much you own of each type. For example, you may choose to include stocks, bonds, real estate and other asset classes in your portfolio. After deciding on your preferred investments, the next step is to choose what percentage of each asset class to include. The ideal percentages can be expressed as ranges, e.g., 60 to 70 percent of one class, 10 to 20 percent of another and 20 to 30 percent of yet another.
There are two general approaches to asset allocation: strategic (often associated with a passive investment style) and tactical (often associated with an active investment style). The strategic approach involves creating a portfolio where the ideal mix of investments is determined at the outset and essentially left alone until something major happens to change your investment needs (such as your reaching retirement, winning a major cash prize, or becoming disabled and no longer able to generate income). The assumption with a strategic style is that your needs, including your risk tolerance, will mostly stay the same over the long term.
The tactical approach to asset allocation starts out the same as the strategic approach, with careful planning according to your needs and the level of risk you are ready to accept. However, with the tactical approach you continually make adjustments to maximize your returns as the market changes or appears to be on the verge of changing. Markets can be unpredictable, so you should hire a professional to advise you. The two factors that have the greatest impact when using this method are the costs involved in ongoing trading and whether or not the forecasts you rely on are accurate.
Diversification Is Essential
Diversification, the incorporation of unrelated assets within a single asset class, is essential for any investment portfolio, no matter what your approach to trading is. This process should occur right after you determine what percentage of each type of asset should make up your portfolio. For example, if you have decided to allocate 40 percent of your portfolio to bonds, you should incorporate a diverse mix of bonds, such as both short- and long-term corporate bonds, government bonds and so on. The same goes for other asset classes. Investing overseas is another effective way to diversify your portfolio.
In addition to selecting a diverse combination of investments based on their obvious differences, you should diversify according to style. For example, when it comes to stocks as an asset class, some are viewed as being growth-oriented, while others in the same class are value-oriented. Growth-oriented stocks have a history of higher-than-average earnings and usually also carry high price-to-earnings ratios. Value-oriented stocks, on the other hand, tend to have low price-to-earnings ratios and high dividends. Having a mix of stocks and other such assets that perform differently over time and under different market conditions helps to reduce risk.
Beware of Over-Diversification
Although diversification is a good and necessary thing in an investment portfolio, it is possible to diversify too much. For example, imagine you invested in 100 different companies when 20 would have been enough to diversify your portfolio. If you had stopped at 20, you would have been able to purchase more shares in each company, enabling you to benefit more from a big gain in one of these firms. Now that you own just a few shares of 100 companies, though, a notable gain for any single one of them is not likely to significantly increase your bottom line.
These are just two basic concepts when it comes to building an investment portfolio, and there is much more to building a solid retirement plan. Navigating the world of investing and retirement planning is tricky business, and the more you have to invest, the more you have to lose. Expert wealth-management professionals, such as Patrick Dwyer Merrill Lynch, have extensive knowledge and experience in the field of financial planning and can help you make decisions in this area.
Improving your investment strategy can be a gradual process as you start to understand the market and all the different asset classes available. Having the appropriate amount of diversification in your portfolio is a balancing act, so do your research and plan your investments intentionally.