There are two basic strategies that can help you reduce the risk in your retirement portfolio: diversification and dollar-cost averaging.
Diversification means avoid placing all your investment eggs in one basket. Investment experts say it is smarter to invest in a number of different investments. You want to have your money in different kinds of investments, so that if anything happens to any one of them, it won't be a disaster. Being diversified across cash, bonds, and stock funds may help reduce the risk in your investments.
Investing gradually rather than all at once, that is, not putting all your money in the stock/bond market in one shot, has certain advantages. The strategy of systematically investing a fixed dollar amount over time is called dollar-cost averaging. For example, if you have $1,200 to shift into a new investment, you would invest $100 per month instead of shifting the whole $1,200 at the beginning of the year. The benefit of dollar-cost averaging is that it reduces the risk of buying shares at the wrong time. The theory is that you buy fewer shares when the price per share is higher and more shares when the price per share is lower. Dollar-cost averaging may work in your favor because the average price per share that you end up purchasing is typically lower. As part of your retirement investing strategy, dollar-cost averaging can be used as you reallocate investments from growth investments to growth and income investments.
Asset allocation is a method of diversifying your long-term investments to help you achieve the highest rate of return for the amount of risk you are willing to accept.
Since no one can really predict what will happen tomorrow, you need a way of investing your money to reach your long-term goals. Rather than focusing on current market conditions and the short-term outlook, you need a strategy that is based on what stage of life you're at and how many years you will be in retirement.
Asset allocation does that and it is based on two simple concepts. First, different asset classes—stocks, bonds and cash—react differently under the same economic conditions. For example, stocks tend do well when inflation is low and interest rates are dropping. Bonds tend to perform well when the economy is slowing down and when interest rates are dropping. Unlike stock prices, bond prices are determined by interest rates rather than investor demand. Cash, while not a growth asset, can act as an anchor when both stocks and bonds are performing poorly.
Second, certain asset classes perform better over time than others. Stocks and stock funds are typically the long-term winners, but have the highest degree of short-term volatility. Bonds, or bond funds, with short-term maturities, typically show less price volatility to changing interest rates than bonds with longer maturities.
Here's the basic point: By selecting a combination of stock and bond funds, you smooth out the short-term volatility—the ups and downs of the markets—while seeking to achieve your long-term results.
Diversification and asset allocation do not ensure a profit or protect against a loss. Dollar-cost averaging cannot guarantee a profit or protect against a loss, and you should consider your financial ability to continue purchases through periods of low price levels.
Repositioning Your Investments
As you approach retirement, you may need to reposition your qualified plan investments to better meet your goals. If you are within five years of retirement and are planning to annuitize your retirement plan balance or take a lump-sum distribution (versus leaving the funds in your employer's plan or moving them to an IRA), you may want to temporarily adopt a short- to mid-term investment philosophy with your qualified retirement plan funds. You may want to lock in some of your equity gains and adopt a more conservative investment approach. Then when you receive the qualified plan amounts, you can implement a long-term strategy.
Whenever you shift your investments, consider using a dollar-cost averaging strategy. The timing for shifting the investments depends on several factors, including the current economic environment, your need for income in retirement, and the amount and structure of your entire portfolio.
Call your financial professional to talk about the investment choices that are best for you. Your financial professional can help you develop an appropriate asset allocation for your retirement assets.