History has shown that throughout time, different types of stocks take turns dominating the market. Some lead the market for years, while others fall out of favor. Therefore, it’s important to consider asset allocation for retirement portfolio to diversify it in a way that protects your money, regardless of what you’re investing in.
Think of it as the opposite of putting all your eggs in one basket, which is never a good idea. Diversifying your portfolio will enable you to have steady growth, since you aren’t just investing in only one type of stock. Essentially, you’re creating a portfolio that moves smoothly, and is constructed in a way so you will never experience catastrophic losses or wild fluctuations.
For example, let’s say the only investment in your portfolio is a fund that invests in small companies with above-average growth (regardless of whether the fund may have been incredibly successful). Because the type of stock was out of favor, you only got an annualized 7% return but if you had invested in a well-performing large-company fund as well, your return would have been much higher.
While diversifying your portfolio, keep in mind that the objective is to minimize risk and volatility, while maximizing gains. Some funds are riskier to invest in than others, for example, sector-specific funds. These funds are very narrowly focused, and have extreme swings in performance.
Financial planners typically recommend that investors make sector-specific funds a very small slice in their portfolio, because investors often see hot funds and decide to invest, often chasing past performance. However, they invest too late to cash in on the returns, and end up losing out.
Another way you can minimize risk is to invest in bonds. While stocks provide the best returns, bonds are a much more conservative investment, in which returns are guaranteed. It’s important to reduce the risk of investing in stocks, because they can behave erratically in the short term. Adding bonds is a great way to create a well-chosen asset allocation.
Overall, diversification is the only way to make sure your investment risk is small and your chance of high returns is optimized.