Diversification

Last updated: April 13, 2016

Balancing Risk and Reward

Once you’ve decided how much to set aside to invest, determine how you’ll spread your money among various types of investments. History proves that different kinds of securities take turns leading the market.

  • Some groups go out of favor or go gangbusters for years at a time.

  • Trends in performance of the different types of investments are difficult to predict.

  • You probably won't experience steady growth if you invest in only one class of securities.

For example:

  • When the tech bubble started to burst in 2000, big-company stocks dropped 10%.

  • However, that same year, small-company stocks rose 12%.

  • Adding bonds to the mix helps to stabilize a portfolio

    • In 2000, 2001 and 2002, when big-company stocks lost 10%, 13% and 23%, respectively, a broad sampling of bonds gained 12%, 8% and 10%.

Don’t forget to make room for a fund that invests in foreign stocks.

  • Since the returns of foreign stocks don’t typically move in lock step with those of U.S. stocks, giving your portfolio some foreign flavor adds diversification.

  • Foreign stocks are especially important because economic growth in many foreign countries, particularly in "emerging nations", rapidly outpaces the growth of the U.S. economy.

How Do You Assemble a Portfolio That Will Reduce Risk and Meet Your Goals?

  • You can do it yourself

                         Or

  • You can choose a mutual fund that is pre-assembled and includes many types of securities.

One of the most common types of diversified funds is target-date retirement funds.

  • The concept is simple. You choose the fund with a name that includes the year closest to when you expect to retire.

  • So, for example, if you will be 34 in 2020 and plan to retire in 2050, you’d choose a fund with 2050 in its name.

These funds are a balanced mix of investments, complete with big-company stocks, small-company stocks, foreign stocks, bonds, and sometimes, less-traditional assets, such as emerging-markets stocks and real estate stocks.

  • As the fund approaches the target date, the mix of investments becomes more conservative, lowering the percentage of assets in stocks in favor of more bonds and cash.

  • This “glide path” is meant to dampen the fund’s volatility as the target date approaches. It should help reduce the likelihood of big losses as you near the year when you’ll want the money.

Don’t assume, that target-date funds come with guarantees that a certain amount of money will be there for you on that date. They don’t.

  • Many 2010 funds, designed for investors nearing retirement, lost 30% or more during the 2007–09 bear market.

  • While that performance was better than the 55% drop in Standard & Poor’s 500-stock index, it was cold comfort for workers forced to delay retirement or retirees who had to scale back their withdrawals to preserve their shrunken account balances.

If you want a portfolio that won’t become more conservative over time, look for funds whose names contain words like “balanced” or phrases like “asset allocation.”

Another way to construct a portfolio is to use index funds or exchange-traded funds.

  • Because these simply follow indexes, you don’t have to worry about analyzing managers or past performance.

    • Just make sure the funds you choose have low management expenses.

Finally, you can construct a portfolio using actively managed funds or a combination of actively managed funds, index funds, and ETFs.

Here are three possible portfolios, with allocations to different types of funds, that you can use as a starting point:  

*The information on this page is credited to IPT and Kiplinger. Their original materials are made available on the Kansas Securities Commissioner's website.

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