When it comes to trying to reduce risk in your 401(k), the phrase "don't put your eggs in one basket" applies. Therefore when selecting investments, it's important to diversify.
The underlying idea is that different asset classes should perform well in different situations. Today, most 401(k) plans provide a variety of investment choices that fall under the following asset categories:
- Stocks help your portfolio grow.
- Bonds generate income and can cushion your portfolio from bear markets.
- Real estate provides a hedge against inflation and low "correlation" to stocks -- in other words, it may rise when stocks fall.
- International investments provide growth and help maintain buying power in an increasing globalized world.
- Cash gives you and your portfolio security and stability.
Together, these offer opportunities for growth as well as the potential to preserve capital during weaker markets.
While our world seems to get smaller every day, the idea behind geographic exposure for your investments is that while the market in Spain might be weak, the market in China could be strong. Depending on global forces, you could diversify your risk between countries with developed economies versus faster growing but more volatile emerging countries. Again, broad international exposure can help manage risk by exposing you to bull markets wherever they may occur.
Keep It Simple
If you're not sure how to allocate across fund choices, don't be a victim of "analysis paralysis." The important thing is to participate in your retirement plan early and often. Diversifying your 401(k) does not have to be complicated. It can be as simple as selecting one S&P 500 index fund and one diversified bond fund. Or many plans offer target date funds that automatically adjust the allocation mix from aggressive to more conservative based on your targeted retirement date. The key takeaway when constructing your 401(k) is to aim to diversify by asset class and geography while keeping your investing costs low.How do you diversify your 401(k)? Is there a rhyme or reason behind your fund selection?