Uncommon Cents

n step two of our total portfolio makeover, we look at a couple of subjects we’ve discussed in the past: asset allocation and diversification.

If you recall, our friend Chris, in her mid-30s, has saved $5,000 and wants to save for retirement. Chris has a minimal risk tolerance and has been counseled about risks outside of net asset value fluctuation and market volatility.

Asset allocation is a sometimes controversial topic; basically it’s how much of your portfolio is dedicated to how much of a particular type of asset. This means at a very basic level that a certain amount of your portfolio is in stock and a certain amount in bonds; it also could mean a further breakdown of a class of asset–for instance, between international stock and domestic stock. Asset allocation is important for reasons we’ve discussed before; it can certainly help you to smooth out the volatility in the stock market, for instance, when it’s volatile by having a high percentage of your portfolio in bonds. It also gives you a certain amount of exposure to various types of markets, which is important because we never know which markets are going to perform well from year to year. Some years, the domestic stock market will return a tremendous amount and bonds next to nothing; other years the bond market will grow by leaps and bounds and the international stock market will be negative. Because of these unpredictable rates of growth in various markets and the incredible difficulty in timing the market, the best answer in my opinion is to be exposed to different markets at all times. For Chris, given her age, I would suggest my standard portfolio of 50% domestic stock, 25% international stock, and 25% high quality domestic bonds. If she finds this too volatile for her taste, she can consider reducing the exposure in both stock categories and increasing it in bonds, perhaps 40% domestic stock, 20% international stock, and 40% high quality domestic bonds.

Diversification is a subject we will cover in depth soon in a Working Backwards piece, but in general diversification means to own a little of a lot of things. Imagine I told you you could have 500 shares of stock and had to choose between 500 shares of a stock in a single company and one share in each of 500 companies. If you choose the former and the company does well, you’ve made out like a bandit; if it doesn’t do very well, you’ve lost a whole lot. If you choose a latter, it doesn’t matter much if one company fails; you have 499 others to bank on. Diversification is another way to manage your risk.

Fortunately, you don’t have to buy 500 individual stocks to be diversified; you can simply buy a single mutual fund or a single share of an exchange traded fund to get a lot of diversification in your portfolio.

In our next look at building Chris a winning retirement portfolio, we will decide exactly which funds to go with for her Roth IRA. Stay tuned!

Tags: Bonds, Goals, Investing, IRAs, Mutual funds, Retirement, Stocks

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