Do you remember when you were very young, and people tried to teach you extraordinarily important financial lessons through easily remembered phrases?
I guess it didn’t work.
Well, anyway, one of those phrases was “don’t put all your eggs in one basket.” When you first heard that phrase, you probably assumed it had to do with the dangers inherent in egg transport. But it was really an all-purpose guideline for investing.
That lesson — place your eggs into multiple baskets, rather than just one — is what diversification and asset allocation are all about.
Of those two concepts, diversification is the easier to understand. It means exactly what it implies, i.e., your investments should be diversified. You don’t want all your money in the stock of one company, even if that company is really wonderful, or is the company you work for, or is both.
By the same token, you don’t want all your money in stocks. You want to diversify into other investments too, like bonds.
Diversification is nothing more than placing your eggs into different baskets.
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The second concept, asset allocation, is only slightly more complicated. It’s about choosing the number of baskets and moving your eggs among them over time.
For example, another of those easily remembered phrases that grown-ups use to try to teach investmenting techniques was that young people have “all the time in the world.”
What that means is that if you’re 25 years old, you can expect to see lots and lots of stock-market declines in your life. But you’re young. You don’t care. A falling market is a buying opportunity for young people. Stocks are cheaper then. So you can buy and hold them.
An older person, however, knows that “time is running out.” Lots of older people who were near (or already in) retirement when the financial crisis hit in 2008 found that they should have changed their asset allocation. Older people are generally better off in safer investments. The young shouldn’t invest like the old, and the old shouldn’t invest like the young.
There are lots of rules and guidelines and advice about just how to allocate your assets based on age. Here’s an article that does a good job of explaining asset allocation.
But whatever diversification and asset-allocation systems you choose, remember not to take any of your gains prematurely. There are tax penalties galore if you cash out a retirement account early.
Or as the growns-up put it, “don’t count your chickens before they hatch.”