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Introduction | Tips For Getting Diversified | Appropriate Diversification | Maximum Portfolio | Investments That Reduce Risk | Assest Class Mixes

Diversify

Some Tips for Getting Diversified.

Most of the techniques for diversifying an investment portfolio come easily to 401(k) investors; the composition of most plans naturally promotes diversification.

Here are some steps to follow when building a diversified investment account.

  • Invest in more than one asset type. You do not have to limit your investments to just one asset class. In fact, most investors hold a diversified portfolio containing stocks, bonds and money market investments. A portfolio such as this has two major advantages. First, you can tailor your investment choices to the level of risk appropriate for your goals, time horizon and risk tolerance. Second, by including all three of these asset types in your portfolio, you take advantage of the fact that they are not perfectly correlated -- that is, each type performs well (or poorly) at different times, so that at any given time one will be up while another is down. This reduces the overall risk of your portfolio.
  • Buy different varieties of the same security type. Within stocks, bonds and cash investments, you can find plenty of variety in terms of risk level and return. Stock investors can get exposure to both the slow and steady performance of blue chip stocks and the exciting growth possibilities of small cap stocks. Investors who buy fixed income instruments can diversify by choosing bonds with different maturity dates and interest rates, such as T-Bills and Treasury bonds. They can also invest in bonds with different credit ratings from the three major rating services, which grade bonds based on their assessment of the issuer's ability to meet payments: the lower a bond's rating, the higher the interest it pays.
  • Invest in different industries. One way to reduce risk is to buy stocks that aren't too closely related. Say, for example, you invested in five chemical companies, you wouldn't really be very diversified, because these stocks would probably move in the same cyclical patterns. But if you invested in a commodity chemical producer, a retail store chain, a media company, a software producer and a maker of breakfast cereals, you could reasonably expect that part of your portfolio would be doing well even when the others weren't.
  • Invest in mutual funds. If you invest in funds, much of the work of diversification will be done for you. Mutual funds are highly diversified investment vehicles -- they have to be under the law -- and even if you only invest in one fund you will still be more diversified than you could be if you bought individual stocks on your own.
  • Diversify among different types of mutual funds. There is a mutual fund for every conceivable investment style. You can find out from the prospectus what types of securities a fund invests in. Even the names of some funds -- Small Cap, Growth and Income, Blue Chip, International, etc. -- give a pretty good indication of what they buy and sell. Don't limit yourself to just one.

Real Estate

The most obvious way to get into the real estate market is to own a property outright. You may want to buy a place to live in, to collect rent on as a landlord, or both. Proponents of real estate as an investment point to one clear advantage: you can make money on a house, but you can't live in a mutual fund.

But real estate investing presents a serious matter of liquidity. An investment is liquid if you can buy and sell it easily and quickly. Anybody who has ever bought or sold a house knows how excruciatingly long this process can be.

You should buy a property because you want to own your home or are interested in being a landlord. Investment diversification isn't enough reason to own real estate.

If, however, you want to get exposure to the real estate market without getting your hands dirty, there are several options. Real estate investment trusts (REITs) are pooled investments in office and apartment buildings, shopping centers and other commercial properties. REIT shares are publicly traded like stocks, and though they are pretty volatile, have historically performed well over the long term. The REIT market grew 1,400% in the period from 1972 to 1996.

Real estate mutual funds invest in a variety of REITs nationwide and also buy shares of real estate-related companies like home construction firms and hotels. By investing in REITs in different regions, real estate funds offer a diversified investment that is not tied solely to the performance of a specific regional market. The advantages associated with mutual funds -- diversification, professional management, liquidity and convenience -- all apply to real estate funds.

Limited partnerships (LP) offer partial ownership in a variety of real estate ventures. In a limited partnership, a senior partner controls day to day management of the investment, while a number of junior partners put up most of the money. In addition to real estate, LPs are also used to finance movies, oil exploration projects and other endeavors. While they offer tax advantages, limited partnerships are often unstable investments, and can be very hard to sell.

Silver and Gold

There are also funds that invest in precious metals. Gold, silver, platinum and the like have a low correlation to other investments, since metals move independently of all stocks. But historical returns on metals indicate that your money could most likely be spent on more profitable investments. There is also an issue of liquidity. It could be argued that a gold coin is a wise investment because it helps to diversify an investment portfolio. While that may be true, it may also take a relatively long time to resell it.

Others

Collectibles like art, vintage cars and memorabilia face the same potential liquidity problem as the gold coin discussed above. Also, their value is highly subjective and their risk tends to be way out of proportion to the potential for appreciation. Buy art and collectibles because you like to look at them, not as investments.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.
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