Diversification breakdown by age
Diversification is important at any age, but there are times when you can and should be riskier with what you invest in. In fact, most money experts encourage younger investors to focus heavily on riskier investments and then shift to less risky investments over time.
The rule of thumb is that you should subtract your age from 100 to get the percentage of your portfolio that you should keep in stocks. That’s because the closer you get to retirement age, the less time you have to bounce back from stock dips.
For example, when you’re 45, you should keep 65% of your portfolio in stocks. Here’s how that breaks down by decade:
- 20-year-old investor: 80% stocks and 20% safer investments, like mutual funds or bonds
- 30-year-old investor: 70% stocks and 30% safer investments, like mutual funds or bonds
- 40-year-old investor: 60% stocks and 40% safer investments, like mutual funds or bonds
- 50-year-old investor: 50% stocks and 50% safer investments, like mutual funds or bonds
- 60-year-old investor: 40% stocks and 60% safer investments, like mutual funds or bonds
- 70-year-old investor: 30% stocks and 70% safer investments, like mutual funds or bonds
Diversification vs. asset allocation
While asset allocation and diversification are often referred to as the same thing, they aren’t. These two strategies both help investors to avoid huge losses within their portfolios, and they work in a similar fashion, but there is one big difference.
Diversification focuses on investing in a number of different ways using the same asset class, while asset allocation focuses on investing across a wide range of asset classes to lessen the risk.
When you diversify your portfolio, you focus on investing in just one asset class, like stocks, and you go deep within the class with your investments.
That could mean investing in a range of stocks that have large-cap stocks, mid-cap stocks, small-cap stocks, and international stocks and it could mean varying your investments across a range of different types of stocks, whether those are retail, tech, energy, or something else entirely but the key here is that they’re all the same asset class: stocks.
Asset allocation, on the other hand, means you invest your money across all categories or asset classes. Some money is put in stocks and some of your investment funds are put in bonds and cash or another type of asset class. There are several types of asset classes, but the more common options include:
- Stocks
- Mutual funds
- Bonds
- Cash
There are also alternative asset classes, which include:
- Real estate, or REITs
- Commodities
- International stocks
- Emerging markets
When using an asset allocation strategy, the key is to choose the right balance of high- and low-risk asset classes to invest in and allocate the right percentage of your funds to lessen the risk and increase the reward.
For example, as a 30-year-old investor, the rule of thumb says to invest 70% in riskier investments and 30% in safer investments to ensure you’re maximizing risk vs. reward.
Well, you could allocate 70% of your investment to a mix of riskier investments, including stocks, REITs, international stocks, and emerging markets, spreading that 70% across all these types of asset classes. The other 30% should go to less risky investments, like bonds or mutual funds, to lessen the risk of losses.
As with diversification, the reason this is done is that certain asset classes will perform differently depending on how they respond to market forces, so investors spread their investments across asset allocations to help protect their money from downturns.
Components of a well-diversified portfolio
In order to have a well-diversified portfolio, its important to have the right income-producing assets in the mix. The best portfolio diversification examples include:
Stocks
Stocks are an important component of a well-diversified portfolio. When you own stock, you own a part of the company.
Stocks are considered riskier than other types of investments because they are volatile and can shrink very quickly. If the price of your stock drops, your investment could be worth less money than you paid if and when you decide to sell it.
But, that risk can also pay off. Stocks also offer the opportunity for higher growth over the long term, which is why investors like them.
While stocks are some of the riskiest investments, there are safer alternatives. For example, you can opt for mutual funds as part of your strategy.
When you own shares in a mutual fund, you own shares in a company that buys shares in other companies, bonds, or other securities. The entire goal of a mutual fund is to lessen the risk of stock market investing, so these are typically safer than other investment types.
Bonds
Bonds are also used to create a well-diversified portfolio. When you buy a bond, you’re lending money in exchange for interest over a fixed amount of time.
Bonds are typically considered safer and less volatile because they offer a fixed rate of return. And, they can act as a cushion against the ups and downs of the stock market.
The downside is that the returns are lower, and are acquired over a longer-term. That said, there are options, like high-yield bonds and certain international bonds, that offer much higher yields, but they do come with more risk.
Cash
Cash is another component of a solid portfolio, and it includes liquid money and the money that you have in your checking and savings accounts, as well as certificates of deposit, or CDs, and savings and treasury bills. Cash is the least volatile asset class, but you pay for the safety of cash with lower returns.
Mario
Technically it is not correct to write "mutual funds" as an asset class. (The VFIFX contains roughly 90% stocks - you currently have a portfolio with 70% stocks).