When it comes to investing, savvy money managers advise that you spread your money around -- that is, "diversify" your investments. Diversification protects you from losing all your assets in a market swoon. The sharp decline in stock prices in recent years are proof enough that putting all your eggs in one basket is a risky strategy.
But in order to diversify correctly, you need to know what kinds of investments to buy, how much money to put into each one, and how to diversify within a particular investment category.
Having a lot of investments does not make you diversified. To be diversified, you need to have lots of different kinds of investments. That means you should have some of all of the following: stocks, bonds, real estate funds, international securities, and cash.
Investments in each of these different asset categories do different things for you.
How do you figure out how much money to put into each investment category?
First, set aside enough money in cash and income investments to handle emergencies and near-term goals. (To learn more about saving for a rainy day, read Nolo's article Emergency Funds: Creating a Cash Reserve.)
Next, use the following rule of thumb: Subtract your age from 100 and put the resulting percentage in stocks; the rest in bonds. In other words, if you're 20 years old, put 80% of your assets in stocks; 20% in bonds. (Most 401(k) plans contain both stock and bond offerings; you can also buy these investments through an IRA.)
Then, in order to diversify your money among the other investment categories, adjust the percentages that you got using the above rule of thumb as follows:
The result: Our hypothetical 20-year-old would have an emergency fund and the remaining assets would be split 75% stocks (of which 25% were international), 15% bonds, and 10% REITs.
Once you've diversified by putting your assets into different categories, you need to diversify again. It's not enough to buy one stock, for instance, you need to have a lot of different types of stocks in that portion of your portfolio. That protects you from being ravaged when a single industry -- say, financial services or health care -- takes it on the chin.
If you're not super rich, diversification while buying individual shares can be costly, because you pay trading fees each time you buy a different stock. The most cost-effective way for investors of modest means -- and that means people who have less than $250,000 to play with -- is to buy mutual funds.
Mutual funds are investment pools that combine the money of many individuals to buy stocks, bonds, real estate, international securities, and the like. To make things really simple, you can buy so-called "index" funds, which purchase all the shares of a particular index, such as the stock market's Standard & Poor's 500 Index of big company stocks. There are also bond index funds, international indexes, real estate index funds, and money market funds, which are essentially an index fund for your cash.
Though diversification protects you from devastating losses, it also costs you in average annual returns. That's because risk and reward go hand-in-hand in the financial markets. So anything that reduces your risk will also reduce your return.
Give yourself permission to take a little risk, unless you're close enough to retirement that the additional security is particularly valuable.
Some people argue that the rule of thumb is too conservative, because it suggests that a 50-year-old, who likely has another 30 years to invest, should have a 50-50 stock and bond mix. These people suggest a better rule of thumb is to subtract your age from 110.
The best answer is one that's geared to you. If a little extra risk won't keep you up at night, this modified rule of thumb can work. But, if it will cause you distress, stick with the original rule of subtracting your age from 100, even if it isn't as lucrative. You'll save money on antacids.
For easy to read, practical advice on planning your family's finances, read The Busy Family's Guide to Money, by Sandra Block, Kathy Chu, and John Waggoner (Nolo).