You can knit together a diversified portfolio of investments.
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Putting part of your
principal into
equities, part into
fixed-income investments, and perhaps part into cash
is only the first step in creating an investment
portfolio. Next, you'll need to decide among individual
investments,
separate account funds within
variable annuities,
mutual funds, or
exchange traded funds (ETFs) within those
asset classes in order to
diversify the portfolio. The first step is identifying
subclasses of investments within each of the three asset classes. And if you're
including other asset classes, you'll want to diversify within them as well.
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In a simplified example, even though a separate account fund that
invests in small-company stock and another one that buys large-company stock are
both equity accounts, they are significantly different investments. Each one exposes
you to different levels of
risk, changes in value at different rates, and may prosper in different
economic circumstances. So when small-company stocks are providing stronger returns
than large-company stocks, a small-company fund in a separate account is likely
to provide a stronger return than a large-company fund in that
separate account, and vice versa.
If you own each type of separate account in your variable annuity, you're positioned
to benefit from a strong return on at least a portion of your portfolio, no matter
which account is providing it. The same general principle applies to individual
stock and
bond investments,
to mutual funds,
and to ETFs.
THE SEESAW PRINCIPLE Diversification
works because, just as the major asset classes tend to move in opposite directions,
so do the subclasses
within them.
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For example, when investors are buying stocks, stocks provide a
strong return and bond returns are likely to be weaker. And when investors get out
of the stock market and buy bonds, bond returns generally strengthen and stock returns
weaken. Similarly, small companies may prosper during a period in the economic cycle
when large companies tend to struggle.
If you keep money invested in a variety of asset subclasses, you can benefit in
two ways. First, you're in a position to profit from strong returns in a particular
subclass. Second, those gains can help offset losses in a class or subclass that's
slowing down.
USING VARIETY WISELY If you're
seeking diversification in your
401(k) or similar plan, and the plan offers just a few choices
in each asset class, making decisions is simpler than it might otherwise be. You
can carry out your strategy with the choices you have, and make sure you diversify
more broadly elsewhere in your overall portfolio.
If you have several choices within a single asset class — say several stock separate
account funds — you'll want to look first at each one's investment objective.
Try to avoid investment in several funds that are all making the same type of investment.
To choose among those that invest in similar ways, you'll want to consider past
performance, fees, and a variety of other factors.
While a separate account fund's name is often a useful clue to the kind of investment
it makes, don't take it at face value. Look first at the prospectus for its
official statement, and then check to see if the fund is classified by research
companies, including
Standard & Poor's,
Lipper Inc., and
Morningstar. You may find that a separate account
fund that describes itself as a small-company account actually has substantial investments
in medium- and large-sized companies. That could mean you're not as diversified
as you'd like to be, and may need to look at other alternatives.
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LOOKING FURTHER AFIELDInternational investments, especially
equities, are also an important part of diversification. Because the world's
economies respond primarily to events and conditions in their homelands or regions,
investing abroad is a way to build a broad-based portfolio. And the opportunity
to invest in emerging as well as developed markets offers a further level of diversification.
While international investing provides diversification simply by raising the number
of potential investment choices, it also adds diversity by spreading your investments
across different regions of the world. For example, putting money into a European
fund or an Asian fund can position you to benefit from potential strength in those
areas during periods when the US economy is sluggish or in
recession or when the value of the dollar is low.
In general, variable annuities, mutual funds, and ETFs provide the simplest way
to invest internationally, since they handle all of the currency and taxation issues
that go along with buying and selling abroad. But you may also consider
American Depositary Receipts (ADRs) issued for the US market
by companies based abroad. And many US companies realize a substantial portion of
their revenue from overseas markets, so they may add an element of international
investment to your portfolio.
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