Knowledge is power, especially when it comes to your financial future.
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Knowledge is power, especially when it comes to your financial future. Learn the basics and some of the complexities of investing and mutual funds through these educational resources.
Asset Allocation, Diversification & Rebalancing
Asset allocation, diversification and rebalancing are three common principles of investing. Even if you know nothing about these principles, you are probably familiar with the wisdom and risk management behind them: Don't put all your eggs in one basket.
Asset allocation is the strategy of portioning your investment portfolio among different asset classes, such as stocks, bonds or cash.
As discussed previously in Basics of Investing, these three asset classes often have unique characteristics and risk/reward profiles. Subsequently, stocks, bonds and cash tend to have low correlation to each other, meaning their markets seldom move in the same direction at the same time.
The asset allocation mix you select usually depends upon your risk tolerance and investment time horizon. By investing in more than one asset category, and depending on how much you allocate to each asset class, you can often reduce the risk that you'll lose money or protect yourself against significant losses.
Diversification takes asset allocation deeper by dividing your portfolio into different categories within each asset class. The challenge, however, is to effectively spread out your investments amongst a wide range of companies and industry sectors, concentrating on those that may perform differently under a variety of market conditions.
Having the knowledge and wherewithal to properly diversify your investments is a challenge. This is why, according to the U.S. Securities and Exchange Commission (SEC), "many investors may find it easier to diversify within asset categories through ownership of mutual funds rather than individual investments." Some mutual funds may invest in thousands of companies, which, in theory, provide a greater amount of diversification and can help smooth volatility.
Diversification does not guarantee a profit or protect against a loss in a declining market.
Every portfolio, over time, will shift from its original asset allocation. This is because, by nature, some investments will outperform others and will take up a larger percentage of your portfolio.
While that can be positive in the short term, you may find your portfolio has drifted from its original allocation and is now weighted more toward either stocks or bonds, which can eventually increase risk or decrease the potential to capture gains.
Rebalancing is returning your portfolio to its intended asset allocation mix, which is the best way to keep your long-term strategy on track. Regular rebalancing is a standard recommendation from most financial professionals, who will either sell off investments or purchase new investments to restore the correct balance.