Retirement Planning: Asset Allocation and Diversification

Once you've determine how much you'll need for retirement, you come to an even bigger question: "What the heck do I invest in?" There is a vast universe to choose from. The correct answer will change over time and depending on the market you encounter.

It isn't practical to discuss in detail the wide array of securities and investing strategies available in the market today, but we will go over the basics you'll need to know to set up your retirement investments. (For more detailed information, check out our Guide to Stock-Picking Strategies and Advanced Bond Concepts tutorials. If you need a refresher – or are looking for more basic information – check out our Stock Basics, Bond Basics and Mutual Fund Basics tutorials.)

If you feel you need assistance understanding and selecting securities to invest in, consider seeking the help of a professional financial planner.

The assets you choose to invest in will vary depending on several factors, primarily your risk tolerance and investment time horizon. The two factors work hand in hand. The more years you have left until retirement, the higher the level of risk you can handle – if you're comfortable with it, that is (see Matching Investing Risk Tolerance to Personality).

How Long Until Retirement

If you have a longer-term time horizon, say 30 years or more until retirement, investing all of your savings into common stocks is probably a reasonable idea. If you are nearing your retirement age and only have a few years left, however, you probably don't want all of your funds invested in the stock market. A downturn in the market a year before you are all set to cash out could put a serious damper on your retirement hopes.

As you get closer to retirement, your risk tolerance usually decreases. It makes sense to perform frequent reassessments of your portfolio and make any necessary changes to your asset allocation.

Generally speaking, if you have a limited time horizon, you should stick with large-cap, blue chip stocks, dividend-paying stocks, high-quality bonds or even virtually risk-free short-term Treasury bills, also called T-bills.

That said, even if you have a long-term time horizon, owning a portfolio of risky growth stocks is not an ideal scenario if you're not able to handle the ups and downs of the stock market. Some people have no problem picking up the morning paper to find out their stock has tanked 10 or 20% since last night, but many others do. The key is to find out what level of risk and volatility you are willing to handle and allocate your assets accordingly.

Of course, personal preferences are second to the financial realities of your investment plan. If you are getting into the retirement game late – or are saving a large portion of your monthly income just to build a modest retirement fund – you probably don't want to be betting your savings on high-risk stocks. On the other hand, if you have a substantial company pension plan waiting in the wings, maybe you can afford to take on a bit more investment risk than you otherwise would, since substantial investment losses won't derail your retirement.

As you progress toward retirement and eventually reach it, your asset allocation needs will change. The closer you get to retirement, the less tolerance you'll have for risk and the more concerned you'll become about keeping your principal safe.

Once you ultimately reach retirement, you'll need to shift your asset allocation away from growth securities and toward income-generating securities, such as dividend-paying stocks, high-quality bonds and T-bills. For more, see Using Time Horizons in Investing.

The Importance of Diversification 

There are countless investment books that have been written on the virtues of diversification, how to best achieve it and even ways in which it can hinder your returns.

Diversification can be summed in one phrase: Don't put all of your eggs in one basket. It's really that simple. Regardless of which type of investments you choose to buy – whether they are stocks, bonds, or real estate – don't bet your retirement on a single asset or asset class.

As you contribute savings to your retirement fund month after month, year after year, the last thing you want is for all your savings to be wiped out by the next Lehman Brothers collapse. And if there's anything we have learned from the Enrons of the world, it's that even the best financial analysts can't predict each and every financial problem.

Given this reality, you absolutely must diversify your investments. Doing so isn't really that difficult, and the financial markets have developed many ways to achieve diversification, even if you have only a small amount of money to invest.

Mutual Funds and ETFs

Consider buying mutual funds or exchange-traded funds (ETFs), if you are starting out with a small amount of capital or aren't comfortable with picking your own investments. Both types of investments work on the same principle – many investors' funds are pooled together and the fund managers invest all the money in a diversified basket of investments.

This can be really useful if you have only a small amount of money to start investing with. It's not really possible to take $1,000, for example, and buy a diversified basket of 20 stocks, since the commission fees for the 20 buy and 20 sell orders would ruin your returns. But with a mutual fund or ETF, you can contribute a small amount of money and own a tiny piece of each of the stocks owned by the fund. In this way, you can achieve a good level of diversification with very little cost.

Active vs. Passive Management

There are many different types of mutual funds and ETFs, but there are two basic avenues you can choose: active management and passive management. Active management means that a fund's managers actively pick stocks and make buy and sell decisions in an attempt to reap the highest returns possible

Passive management, on the other hand, simply invests in an index that follows the overall stock market, such as the S&P 500. In this arrangement, stocks are only bought when they are added to the index and sold when they are removed from the index. In this way, passively managed index funds mirror the index they are based on. Since indexes such as the S&P 500 essentially are the overall stock market, you can invest in the overall stock market over the long term simply by buying and holding shares in an index fund. (To learn more about passively and actively managed funds, check out our Index Investing and Mutual Fund Basics tutorials.)

If you do have a sizable amount of money with which to begin your retirement fund and are comfortable picking your own investments, you could realistically build your own diversified portfolio. For example, if you wanted to invest your retirement fund in stocks, you could buy about 20 stocks, a few from each economic sector. Provided none of the companies in your portfolio are related, you should have a good level of diversification.

The Bottom Line

No matter how you choose to diversify your retirement holdings, make sure that they are indeed diversified. There is no exact consensus on how many stocks a portfolio needs to be adequately diversified, but the number is most likely greater than 10. Going to 20 or even a bit higher isn't going to hurt you.