Are your investments properly diversified? How do you know? Diversification simply means that you don’t have all of your eggs in one basket. The more different types of investments you have the more diversified you are.
Asset allocation is a scientific approach to diversification. First, we must carefully define the investment categories. The first breakdown is between equities (stocks and mutual funds that represent ownership of a company) and fixed income (bonds, CD’s and the like, which are simply loans of money to a company).
Equities can be further broken down by the size of the company, foreign vs. domestic, industry, etc. Bonds are usually categorized by maturity and credit quality.
The next step is to define your targets – what percentage of your investments do you want to have in each category? This depends on your time horizon, risk tolerance and need for income. Ultimately you want to construct a portfolio that provides the growth and income you need and minimizes the risk and fluctuations.
While many brokerage firms and mutual fund companies offer help with this, the approach is generally simplistic and not tailored to an individual’s needs. An experienced advisor who understands correlation and tax-efficiency can help you define and implement targets that meet your precise goals.