Last Updated: August 17, 2009
You've probably heard TV commentators refer to something called the "Goldilocks economy." It's an economy that's not too hot (moving so high and fast it's poised for a huge fall) or too cold (meandering with no immediate upside) but just right, which means somewhere comfortably in the middle.
There's also a "Goldilocks" factor to proper diversification, though it depends as much on your own personal factors as well as what's happening in the market. Proper diversification happens when you consider the time it will take to reach your specific financial goals based on your age, risk tolerance and assets, and then use that information to make investment choices that counterbalance each other no matter how hot or cold markets get.
There are plenty of ready-made solutions to diversification on the market. You may have heard about target date mutual funds and target risk mutual funds. Target date funds allow an investor to select a fund that corresponds their current age and their year of their planned retirement, and the portfolio will automatically adjust to fit that profile. A target risk fund isn't tied to a specific retirement date but how much risk you're willing to take on — these funds have been around for years and are directed toward investors who can describe their investment philosophy in a word — aggressive, moderate or conservative.
Is ready-made the right way to go? If it's the difference between saving and not saving, yes. But chances are you can do better with personalized advice. A financial professional can take a closer look at what you really want to do with your money and help you design a diversified portfolio tailored to the way all of the following factors apply to you:
- Your specific financial goals
- Current assets
- Risk tolerance
How do you know if you need help diversifying a portfolio? Here are some questions to ask yourself:
How do you view your retirement? Today's retirement ideal is changing. If your health picture is good and you're not quite willing to give up work altogether, it's wise to design a plan for a full- or part-time post-retirement career or extensive volunteer work. Can a product that automatically changes your diversification picture every year foresee the investment performance and tax issues that may surface in a working retirement? Not likely.
How would your portfolio weather a serious market downturn? Based on your retirement scenario, are you diversified enough in various asset classes (stocks, bonds, cash or real estate) that the overall value of your retirement portfolio wouldn't severely suffer if one or more of your asset classes suffered a serious downturn? When the market bubble popped in 2000, many investors who were invested heavily in growth stocks suffered because they didn't have other investments positioned for gains or at least stability against those losing value.
Are you adequately covered for worst-case scenarios? Granted, Social Security and Medicare — for as long as they last — will always offer some degree of safety net to retirees, but have you also planned savings and investments outside your retirement fund to cover possible health and unexpected financial emergencies in your post-retirement years? A planner can help you check your investment diversification as the years go by to make sure you are prepared for any eventuality.
Will you know how to keep fees under control? Targeted investment plans automatically re-allocate your holdings based on your investment timeframe, but they generally charge higher fees to do so. Self-managed portfolios of individual stocks might become fairly costly if you trade often. To get a properly diversified portfolio of investments, you need to understand the various fees and costs associated with them and whether there might be more affordable alternatives. Fees should be reasonable in relation to overall performance.
How will you avoid over-diversification? First of all, what is over-diversification? It doesn't pertain to the overall amount invested, but how that money is allocated. Simply, money spread across too many different kinds of investments can mean that a positive gain in any single one won't make that much of a difference in the overall value of your portfolio. Are there rules of thumb? Some believe you shouldn't own more than 15-20 individual stocks or mutual funds in more than four or five asset classes that don't overlap each other.
When hiring a planner, it's always appropriate to ask what his or her approach to diversification would be relative to your particular situation and why.