Beginners' Guide To Asset Allocation, Diversification, And Rebalancing

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Beginners’ Guide to Asset Allocation, Diversification,and RebalancingEven if you are new to investing, you may already knowsome of the most fundamental principles of soundinvesting. How did you learn them? Through ordinary,real-life experiences that have nothing to do with thestock market.For example, have you ever noticed that street vendorsoften sell seemingly unrelated products - such as umbrellas and sunglasses? Initially, that may seem odd.After all, when would a person buy both items at thesame time? Probably never - and that’s the point. Streetvendors know that when it’s raining, it’s easier to sellumbrellas but harder to sell sunglasses. And when it’ssunny, the reverse is true. By selling both items - in other words, by diversifying the product line - the vendorcan reduce the risk of losing money on any given day.If that makes sense, you’ve got a great start on understanding asset allocation and diversification. Thispublication will cover those topics more fully and willalso discuss the importance of rebalancing from time totime.Let’s begin by looking at asset allocation.Asset Allocation 101Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks,bonds, and cash. The process of determining which mixof assets to hold in your portfolio is a very personal one.Investor Assistance (800) 732-0330The asset allocation that works best for you at any givenpoint in your life will depend largely on your time horizon and your ability to tolerate risk.Time HorizonYour time horizon is the expected number ofmonths, years, or decades you will be investing to achieve a particular financial goal. Aninvestor with a longer time horizon may feelmore comfortable taking on a riskier, or morevolatile, investment because he or she can waitout slow economic cycles and the inevitableups and downs of our markets. By contrast,an investor saving up for a teenager’s collegeeducation would likely take on less risk because he or she has a shorter time horizon.Risk ToleranceRisk tolerance is your ability and willingnessto lose some or all of your original investmentin exchange for greater potential returns. Anaggressive investor, or one with a high-risktolerance, is more likely to risk losing moneyin order to get better results. A conservativeinvestor, or one with a low-risk tolerance,tends to favor investments that will preservehis or her original investment. In the words ofthe famous saying, conservative investors keepa “bird in the hand,” while aggressive investorsseek “two in the bush.”www.investor.gov1

Risk versus RewardWhen it comes to investing, risk and reward are inextricably entwined. You’ve probably heard the phrase “nopain, no gain” - those words come close to summingup the relationship between risk and reward. Don’t letanyone tell you otherwise. All investments involve somedegree of risk. If you intend to purchase securities such as stocks, bonds, or mutual funds - it’s importantthat you understand before you invest that you couldlose some or all of your money.The reward for taking on risk is the potential for a greater investment return. If you have a financial goal with along time horizon, you are likely to make more moneyby carefully investing in asset categories with greaterrisk, like stocks or bonds, rather than restricting yourinvestments to assets with less risk, like cash equivalents.On the other hand, investing solely in cash investmentsmay be appropriate for short-term financial goals.Investment ChoicesWhile the SEC cannot recommend any particular investment product, you should know that a vast array ofinvestment products exists - including stocks and stockmutual funds, corporate and municipal bonds, bondmutual funds, lifecycle funds, exchange-traded funds,money market funds, and U.S. Treasury securities.For many financial goals, investing in a mix of stocks,bonds, and cash can be a good strategy. Let’s take acloser look at the characteristics of the three major assetcategories.StocksStocks have historically had the greatest riskand highest returns among the three major asset categories. As an asset category, stocks are aportfolio’s “heavy hitter,” offering the greatestpotential for growth. Stocks hit home runs,but also strike out. The volatility of stocksmakes them a very risky investment in theshort term. Large company stocks as a group,Investor Assistance (800) 732-0330for example, have lost money on average aboutone out of every three years. And sometimesthe losses have been quite dramatic. But investors that have been willing to ride out thevolatile returns of stocks over long periods oftime generally have been rewarded with strongpositive returns.BondsBonds are generally less volatile than stocksbut offer more modest returns. As a result, aninvestor approaching a financial goal mightincrease his or her bond holdings relative tohis or her stock holdings because the reducedrisk of holding more bonds would be attractiveto the investor despite their lower potential forgrowth. You should keep in mind that certaincategories of bonds offer high returns similarto stocks. But these bonds, known as highyield or junk bonds, also carry higher risk.CashCash and cash equivalents - such as savingsdeposits, certificates of deposit, treasury bills,money market deposit accounts, and moneymarket funds - are the safest investments, butoffer the lowest return of the three major assetcategories. The chances of losing money onan investment in this asset category are generally extremely low. The federal governmentguarantees many investments in cash equivalents. Investment losses in non-guaranteedcash equivalents do occur, but infrequently.The principal concern for investors investingin cash equivalents is inflation risk. This isthe risk that inflation will outpace and erodeinvestment returns over time.Stocks, bonds, and cash are the most common assetcategories. These are the asset categories you wouldlikely choose from when investing in a retirement savings program or a college savings plan. But other assetcategories - including real estate, precious metals andother commodities, and private equity - also exist, andsome investors may include these asset categories withina portfolio. Investments in these asset categories typi-www.investor.gov2

cally have category-specific risks. Before you make anyinvestment, you should understand the risks of theinvestment and make sure the risks are appropriate foryou.Why Asset Allocation Is So ImportantBy including asset categories with investment returnsthat move up and down under different market conditions within a portfolio, an investor can protect againstsignificant losses. Historically, the returns of the threemajor asset categories have not moved up and down atthe same time. Market conditions that cause one assetcategory to do well often cause another asset category tohave average or poor returns. By investing in more thanone asset category, you’ll reduce the risk that you’ll losemoney and your portfolio’s overall investment returnswill have a smoother ride. If one asset category’s investment return falls, you’ll be in a position to counteractyour losses in that asset category with better investmentreturns in another asset category.The Magic of DiversificationThe practice of spreading money among differentinvestments to reduce risk is known as diversification. By picking the right group of investments,you may be able to limit your losses and reducethe fluctuations of investment returns withoutsacrificing too much potential gain.In addition, asset allocation is important because it hasa major impact on whether you will meet your financialgoal. If you don’t include enough risk in your portfolio,your investments may not earn a large enough returnto meet your goal. For example, if you are saving fora long-term goal, such as retirement or college, mostfinancial experts agree that you will likely need to include at least some stock or stock mutual funds in yourportfolio. On the other hand, if you include too muchrisk in your portfolio, the money for your goal may notbe there when you need it. A portfolio heavily weightedin stock or stock mutual funds, for instance, would beinappropriate for a short-term goal, such as saving for afamily’s summer vacation.Investor Assistance (800) 732-0330How to Get StartedDetermining the appropriate asset allocation model fora financial goal is a complicated task. Basically, you’retrying to pick a mix of assets that has the highest probability of meeting your goal at a level of risk you can livewith. As you get closer to meeting your goal, you’ll needto be able to adjust the mix of assets.If you understand your time horizon and risk tolerance- and have some investing experience - you may feelcomfortable creating your own asset allocation model.“How to” books on investing often discuss general“rules of thumb,” and various online resources can helpyou with your decision. For example, although the SECcannot endorse any particular formula or methodology,the Iowa Public Employees Retirement System ( offers an online asset allocation calculator. Inthe end, you’ll be making a very personal choice. Thereis no single asset allocation model that is right for everyfinancial goal. You’ll need to use the one that is right foryou.Some financial experts believe that determining yourasset allocation is the most important decision thatyou’ll make with respect to your investments - that it’seven more important than the individual investmentsyou buy. With that in mind, you may want to considerasking a financial professional to help you determineyour initial asset allocation and suggest adjustments forthe future. But before you hire anyone to help you withthese enormously important decisions, be sure to do athorough check of his or her credentials and disciplinaryhistory.The Connection Between Asset Allocationand DiversificationDiversification is a strategy that can be neatly summedup by the timeless adage, “don’t put all your eggs in onebasket.” The strategy involves spreading your moneyamong various investments in the hope that if one investment loses money, the other investments will morethan make up for those losses.Many investors use asset allocation as a way to diverwww.investor.gov3

sify their investments among asset categories. But otherinvestors deliberately do not. For example, investingentirely in stock, in the case of a twenty-five year-oldinvesting for retirement, or investing entirely in cashequivalents, in the case of a family saving for the downpayment on a house, might be reasonable asset allocation strategies under certain circumstances. But neitherstrategy attempts to reduce risk by holding differenttypes of asset categories. So choosing an asset allocationmodel won’t necessarily diversify your portfolio. Whether your portfolio is diversified will depend on how youspread the money in your portfolio among differenttypes of investments.Diversification 101A diversified portfolio should be diversified at two levels:between asset categories and within asset categories.So in addition to allocating your investments amongstocks, bonds, cash equivalents, and possibly other assetcategories, you’ll also need to spread out your investments within each asset category. The key is to identifyinvestments in segments of each asset category that mayperform differently under different market conditions.One way of diversifying your investments within anasset category is to identify and invest in a wide range ofcompanies and industry sectors. But the stock portionof your investment portfolio won’t be diversified, forexample, if you only invest in only four or five individual stocks. You’ll need at least a dozen carefully selectedindividual stocks to be truly diversified.Because achieving diversification can be so challenging,some investors may find it easier to diversify within eachasset category through the ownership of mutual fundsrather than through individual investments from eachasset category. A mutual fund is a company that poolsmoney from many investors and invests the money instocks, bonds, and other financial instruments. Mutualfunds make it easy for investors to own a small portionof many investments. A total stock market index fund,for example, owns stock in thousands of companies.That’s a lot of diversification for one investment!Be aware, however, that a mutual fund investmentdoesn’t necessarily provide instant diversification, espeInvestor Assistance (800) 732-0330cially if the fund focuses on only one particular industry sector. If you invest in narrowly focused mutualfunds, you may need to invest in more than one mutualfund to get the diversification you seek. Within assetcategories, that may mean considering, for instance,large company stock funds as well as some small company and international stock funds. Between asset categories, that may mean considering stock funds, bondfunds, and money market funds. Of course, as you addmore investments to your portfolio, you’ll likely payadditional fees and expenses, which will, in turn, loweryour investment returns. So you’ll need to considerthese costs when deciding the best way to diversify yourportfolio.Options for One-Stop Shopping- LifecycleFundsTo accommodate investors who prefer to use oneinvestment to save for a particular investmentgoal, such as retirement, some mutual fund companies offer a product known as a “lifecycle fund.”A lifecycle fund is a diversified mutual fund thatautomatically shifts towards a more conservativemix of investments as it approaches a particularyear in the future, known as its “target date.” Alifecycle fund investor picks a fund with the righttarget date based on his or her particular investment goal. The managers of the fund then makeall decisions about asset allocation, diversification,and rebalancing. It’s easy to identify a lifecyclefund because its name will likely refer to its targetdate. For example, you might see lifecycle fundswith names like “Portfolio 2015,” “RetirementFund 2030,” or “Target 2045.”Changing Your Asset AllocationThe most common reason for changing your asset allocation is a change in your time horizon. In other words,as you get closer to your investment goal, you’ll likelyneed to change your asset allocation. For example, mostpeople investing for retirement hold less stock andmore bonds and cash equivalents as they get closer toretirement age. You may also need to change your assetMarch 20114

allocation if there is a change in your risk tolerance,financial situation, or the financial goal itself.But savvy investors typically do not change their assetallocation based on the relative performance of assetcategories - for example, increasing the proportion ofstocks in one’s portfolio when the stock market is hot.Instead, that’s when they “rebalance” their portfolios.Rebalancing 101Rebalancing is bringing your portfolio back to youroriginal asset allocation mix. This is necessary becauseover time some of your investments may become out ofalignment with your investment goals. You’ll find thatsome of your investments will grow faster than others.By rebalancing, you’ll ensure that your portfolio doesnot overemphasize one or more asset categories, andyou’ll return your portfolio to a comfortable level ofrisk.For example, let’s say you determined that stock investments should represent 60% of your portfolio. Butafter a recent stock market increase, stock investmentsrepresent 80% of your portfolio. You’ll need to eithersell some of your stock investments or purchase investments from an under-weighted asset category in orderto reestablish your original asset allocation mix.When you rebalance, you’ll also need to review theinvestments within each asset allocation category. If anyof these investments are out of alignment with yourinvestment goals, you’ll need to make changes to bringthem back to their original allocation within the assetcategory.There are basically three different ways you can rebalance your portfolio:3. If you are making continuous contributions to theportfolio, you can alter your contributions so thatmore investments go to under-weighted asset categories until your portfolio is back into balance.Before you rebalance your portfolio, you should consider whether the method of rebalancing you decide to usewill trigger transaction fees or tax consequences. Your financial professional or tax adviser can help you identifyways that you can minimize these potential costs.Stick with Your Plan:Buy Low, Sell High - Shifting money away froman asset category when it is doing well in favoran asset category that is doing poorly may not beeasy, but it can be a wise move. By cutting backon the current “winners” and adding more of thecurrent so-called “losers,” rebalancing forces youto buy low and sell high.When to Consider RebalancingYou can rebalance your portfolio based either on thecalendar or on your investments. Many financial experts recommend that investors rebalance their portfolios on a regular time interval, such as every six ortwelve months. The advantage of this method is thatthe calendar is a reminder of when you should considerrebalancing.Others recommend rebalancing only when the relativeweight of an asset class increases or decreases more thana certain percentage that you’ve identified in advance.The advantage of this method is that your investmentstell you when to rebalance. In either case, rebalancingtends to work best when done on a relatively infrequentbasis.1. You can sell off investments from over-weightedasset categories and use the proceeds to purchaseinvestments for under-weighted asset categories.2. You can purchase new investments for underweighted asset categories.Investor Assistance (800) 732-0330March 20115

Where to Find More InformationQuestions or Complaints?For more information on investing wisely and avoidingcostly mistakes, please visit the Investor Informationsection of the SEC’s website. You also can learn moreabout several investment topics, including asset allocation, diversification and rebalancing in the context ofsaving for retirement by visiting FINRA’s Smart 401(k)Investing website as well as the Department of Labor’sEmployee Benefits Security Administration website.We want to hear from you if you encounter a problemwith a financial professional or have a complaint concerning a mutual fund or public company. Please sendus your complaint using our online Complaint Center.You can also reach us by regular mail at:You can find out more about your risk tolerance bycompleting free online questionnaires available onnumerous websites maintained by investment publications, mutual fund companies, and other financial professionals. Some of the websites will even estimate assetallocations based on responses to the questionnaires.While the suggested asset allocations may be a usefulstarting point for determining an appropriate allocationfor a particular goal, investors should keep in mind thatthe results may be biased towards financial products orservices sold by companies or individuals maintainingthe websites.Securities and Exchange CommissionOffice of Investor Education and Assistance100 F Street, N.E.Washington, D.C. 20549-0213www.sec.govThe Office of Investor Education and Advocacyhas provided this information as a service toinvestors. It is neither a legal interpretation nora statement of SEC policy. If you have questions concerning the meaning or application ofa particular law or rule, please consult with anattorney who specializes in securities law.Once you’ve started investing, you’ll typically have access to online resources that can help you manage yourportfolio. The websites of many mutual fund companies, for example, give customers the ability to run a“portfolio analysis” of their investments. The resultsof a portfolio analysis can help you analyze your assetallocation, determine whether your investments arediversified, and decide whether you need to rebalanceyour portfolio.***Investor Assistance (800) 732-03306

mutual funds, corporate and municipal bonds, bond mutual funds, lifecycle funds, exchange-traded funds, money market funds, and U.S. Treasury securities. For many financial goals, investing in a mix of stocks, bonds, and cash can be a good strategy. Let's take a closer look at the characteristics of the three major asset categories. Stocks

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