Don't Put All Your Nest Eggs in One Basket
Allocating your 401(k) is key to a happy retirement.
In other words, it is generally more important to determine how much of your 401(k) pie should be divided among stocks, bonds, cash, or other asset classes than it is to decide how much of a particular piece of the pie, such as stocks, should be tied up in, say, Exxon (XOM), Microsoft (MSFT), Bank of America (BAC), or various equity mutual funds.
As a general rule, your asset allocation choices shape your returns over time.
If you've experienced losses during the past market decline that are driving you to rethink your 401(k) approach, then perhaps your asset allocation strategy requires scrutiny.
Truly Saving for Retirement
The process of diverting a portion of one's income into a 401(k), IRA, or related vehicle is often referred to as "saving for retirement." Saving constitutes setting aside resources today for consumption in the future. Risk, or potential for loss, associated with saved resources should be low. This is because you want those resources in your "nest egg" to be there when you need them. When you divert part of your current income and allocate it toward cash or other low risk instruments in your retirement account, then you are indeed saving for retirement.
Typically, however, people do not allocate large amounts of retirement resources toward low-risk saving vehicles. Instead, retirement capital is often tied up in risky assets like stocks. Because potential for loss is significant, a nest egg linked to this approach may not grow and may even shrink for extended periods of time depending on market conditions.
The point is that if you are truly saving for retirement, then your asset allocation choices are relatively straightforward. Allocate your retirement resources among low-risk asset classes such as money market funds, certificates of deposit (CDs), and short-term government bonds that protect principal while generating interest.
Growth of your retirement account will be a function of your savings rate and of the compounding effect. A salient feature of this approach is its stability, which makes retirement planning more reliable.
On the other hand, if you load your 401(k) with stocks, mutual funds, and other risky assets, then you are not saving for retirement. Instead, you are investing, or speculating, for retirement. You are essentially betting that the risk associated with these assets will be mitigated by superior returns.
This bet may pay off handsomely. But it may not. Compared to the saving approach, retirement accounts values based on investing are less predictable and more difficult to plan for.
For those who choose to invest rather than save resources for retirement purposes, asset allocation is a primary mechanism for balancing risk and reward. General asset allocation strategies depend in part on how far away you are from retirement.
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