If you offer both umbrellas and ice cream, however, you’ll be better diversified and are likely to experience steadier sales since you have desirable products come rain or shine. Diversification in your 401(k) works in a similar manner.
Investments don't react to the weather like ice cream and umbrellas, of course, but they do react to economic conditions. Growth helps stocks, but can hurt government bonds. Rising prices hurt bonds, but benefit Treasury inflation-protected securities (TIPS). A rising dollar can be bad for US automakers, but good for Japanese manufacturers, and so on. At FutureAdvisor, we take into account the host of diverse interactions between investments to construct a portfolio based on 12 different asset classes. This approach tends to provide an attractive return while helping to control risk.
Diversification works on two levels:
1. Asset Class
Different asset classes do well in different situations. The main asset classes in which we invest at FutureAdvisor are stocks, bonds, real estate, and inflation-protected securities. Together, these offer growth as well as the potential to preserve capital during weaker markets.
The market may be soaring in China, but plummeting in France. Broad international exposure can help manage this risk, exposing you to bull markets wherever they may occur.
Here’s the takeaway: when constructing your 401(k), aim to diversify by asset class and geography while keeping your investing costs low. 401(k)s are often an attractive investment given employer matching and tax efficiency, even though they may only offer limited or expensive investment options. If you can't access the range of investments you need within your 401(k), consider balancing your portfolio by owning additional assets in a taxable account or an IRA.
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