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Asset allocation reduces volatility

Your retirement nest egg shouldn't actually be one egg, but many, and you definitely don't want to put them all in one basket.

That's the philosophy behind asset allocation, the practice of dividing your retirement savings among different asset classes. You put one egg into stocks, another into bonds, yet another in real estate, and so on.

No, you won't end up with scrambled eggs. By spreading your money around into different categories of investments, you can minimize risk and maximize performance. How does this happen? When you diversify among investments with little correlation to one another, some assets will go up while others go down. When they move in opposition to one another, they have a negative correlation. In effect, this helps stabilize the portfolio and reduce overall volatility.

Asset allocation basics

For example, studies show that Real Estate Investment Trusts (REITs) have little correlation to the stock market. "In '98, the stock market was going through the roof while Real Estate Investment Trusts were losing ground," says Doug Charney, senior vice president of the Charney Investment Group of Wachovia Securities. "The opposite was true in 2001 and 2002. Stocks were down while real estate was doing well."

Bonds also performed well during the two-year period when stocks were sucking wind.

Mitigating risk
That's why asset allocation is so important. "It doesn't eliminate risk, but it helps you deal with it," says Stuart Ritter, a certified financial planner with T. Rowe Price. "When something bad is happening in international stocks, your technology stocks may be doing well and the impact on your portfolio is lessened."

Asset allocation is by far the most important thing that you can do.

Investors often focus too much on choosing the right mutual fund rather than looking at how they are divvying up their retirement savings. It may not be as much fun as choosing the next high-flying, emerging markets fund or acting on a hot stock tip from your brother-in-law, but asset allocation can translate into more money for your retirement.

"Asset allocation is by far the most important thing that you can do," says Jerry Miccolis, a certified financial planner with Brinton Eaton Wealth Advisors in Morristown, N.J. "It is more important than which mutual funds you invest in or what stocks you buy. Getting asset allocation right is 80 percent or 90 percent of the game."

These are typical asset categories:

  • Stocks have several subcategories according to size, price and other financial characteristics. These include value, growth, large-cap, mid-cap, small-cap, domestic, foreign and emerging markets. They can also be classified by sector, specific geographic regions and other variables. Generally, stocks offer the highest returns but carry the most risk.
    Next: "Goals, time, risk tolerance"
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