Establishing a diversified investment portfolio is the go-to method for balancing risk and reward. Although mutual funds already hold a basket of investments, many mutual funds focus on a subset of the entire market of stocks, bonds and other securities. For example, there are funds for large-cap stocks, small-cap stocks, long-term bonds, short-term bonds and more.
Through asset allocation, your funds are placed in different types of investments to further diversify your portfolio — reducing the risk that a single type of investment will leave you with nothing.
With a comfortable asset allocation strategy, you can build a portfolio that fits your investment mentality, however risky or conservative it may be.
Usually, the younger you are, the riskier your asset allocation — heavily weighted in stock funds. As you approach retirement, you reduce the risk by adding more weight in bond funds and income-producing funds.
A popular rule-of-thumb to calculate the stock-bond split to have a percentage of your investment in stock that is equivalent to 120 minus your age. If you are 30 years old, your asset allocation would be comprised of 90 percent stocks and 10 percent bonds. At 60, you would have 60 percent in stocks and 40 percent in bonds. Of course, you can tweak these percentages until your asset allocation matches your risk tolerance.
After deciding the right split between stock and bonds, you then have to decide what types of stock funds and bond funds will comprise their respective portions of your portfolio. There is no right way to take on this endeavor, but try to get a good mix of U.S. stocks, foreign stocks, government bonds, corporate bonds, international bonds and other securities.
An easy way to manage asset allocation is to select a target-date fund, which maintains the stock-bond split that is appropriate for your age. You choose a year in which you aim to retire and the fund will automatically adjust the asset allocation as you get older.