There is an old proverb that says don’t put all your eggs in one basket. The logic behind this saying is very simple to understand. If all your eggs are in the same basket and you dropped your basket all of your eggs would be broken. Therefore, to reduce the risk of losing all your eggs at the same time, you should distribute your eggs across several baskets.
The same logic holds true with investing. When selecting the mix of stocks in your 401(k), IRA or Roth IRA, you need to ensure that you have the right asset mix to mitigate risk. This is called asset allocation.
Why Is Asset Allocation Important
Asset allocation seeks to diversify your portfolio to balance risk.
Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance, and investment horizon. Wikipedia defines asset allocation as the rigorous implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor’s risk tolerance, goals and investment time frame.
For example, in the thrift plan offered to government employees, investors can select from a mix of asset classes to fund their 401(k). These asset classes include:
Let’s say that you developed a portfolio of 42% Equity Index, 23% International Equity, 11% Bond Index, 10% Small Company Equity, 9% Emerging Market Equity, 3% Real Estate Index Fund, 1% Government Securities, and 1% TIPS Index Fund. With this asset allocation, you probably believe that you have a well-diversified and balanced portfolio. However, if the bulk of your money is tied up in your 401(k) plan then I would argue that you are not diversified nor do you have a proper asset allocation. All your eggs are in one easy to get to basket.
A Well-balanced Diet
It’s like if you begin with a plate of food that only contains beef. To diversify your plate you add fish, chicken, turkey, lamb, and some pork. You now have a diversified plate of meat.
Is a plate with only meat a well-balanced diet? Certainly not.
A well-balanced plate would include a protein such as animal protein or beans, a starch that includes rice or potatoes, a salad, and a piece of bread.
To achieve a well-balanced portfolio and proper asset allocation your investments must be distributed across several asset classes including foreign currencies, stocks, bonds, tangible real estate, and physical precious metals. I’m not a fan of bitcoin, but you could even add this to your investment portfolio. This way, if one asset group goes down in value you won’t lose all your eggs. Many assets classes have an inverse correlation. When one asset goes up in price the other goes down. Alternatively, when the same asset goes down in price the other goes up.
Here Is The Conclusion
The point is to never have only one source of income. A proper asset allocation and diversification strategy are imperative in order to have a well-balanced portfolio that can provide you with a source of income and liquidity no matter the state of the economy.