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Mix it up: Diversify!
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When it comes to investments, diversity is strength.
Why diversifying your investments is so important
Deciding to take the plunge and start investing is an important step—but it's only the first one. Next you have to decide exactly how you'll put your money to work for you. That entails deciding how much you'll invest in stocks and how much you'll put into bonds. The amount you invest in stocks versus bonds versus the amount you hold in cash is called your asset allocation.
Historically speaking, stocks will pay off more over the long run. But they're also more prone to dizzying short-term dips along the way. By turning to bonds, you can trade some of that long-term upside for short-term stability.
And no portfolio is complete without some cash on hand, in a bank, which in the U.S. is insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000.
Understanding your risk tolerance and time horizon
So how do you figure out how to divvy up your investments? What investors call your time horizon—basically, the amount of time until you'll need the money you're investing—plays a huge role in that decision. You'll also need to figure out how well you can—or can't—cope with risk. This is what the financial professionals refer to as risk tolerance.
As a general rule, the longer you can wait things out and keep your focus on the longer term, the more stocks you'll want to have in your portfolio. The closer you get to needing the money you've invested and the more likely you are to lose sleep over short-term market shifts, the more you'll want to have in bonds.
Diversity within asset classes
After you've settled on your asset allocation, it's time to consider diversification. Within each asset class, you want to have a mix of:
- Company sizes. Sometimes a roaring economy favors large corporations with existing revenue streams. Other times, more nimble startups do better.
- Industry type. Changing economic trends affect different types of companies in different ways. For example, if oil prices rise, that's good for solar panel makers—and bad for airlines, which need to buy fossil fuels.
- Geography. At any time, some countries might be flying while others are flailing. Most of your portfolio will probably be in US. securities, but you may want to invest in companies based in emerging markets like India and Brazil.
- Bond maturities and risk. Bonds can be long-term or short-term, high-risk or low-risk. Some grow tax-free, while others protect against inflation.
How to maintain a balanced risk profile
Once you've locked in your asset allocation, you'll need to keep an eye out for major market moves that might change your asset allocation without you realizing it. If the value of your stock holdings goes way up or way down, you may need to rebalance your portfolio by doing some buying and selling to bring it back in line with your strategy.
As you decide on the best mix of assets, keep in mind that stock markets have always recovered from losses and gone on to earn more, even outpacing inflation.
If your retirement is still decades away, you can generally refrain from pressing the panic button when Wall Street swoons.
As you get closer to your goal, though, you'll probably want to trim your equities and increase your bond holdings in order to stay on course.
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