Diversification and asset allocation

Two terms you will hear when looking for an investment strategy are diversification and asset allocation. While they may have similar meanings, they are different approaches to investing.

Diversification, simply put, is spreading your risk across asset classes of similar securities. The three core asset classes are stocks, bonds and cash equivalents but within each of these groups are classes based on the varying characteristics of the core class. For example, stocks can be from large, small or foreign companies while bonds may be issued by corporations or government entities and have long or short-term maturities. It is important to note that diversification does not assure a profit or protect against loss in a declining market.

One way to diversify your portfolio would be to purchase shares of three or four stock mutual funds with different objectives. Each mutual fund offers a diverse portfolio by itself, but you can get even more diversification by purchasing shares of funds with differing objectives. As the objectives differ, the chance of two or more mutual funds holding the same stocks is less.

For example, a mutual fund made up of the stocks of larger companies, such as the State Farm Equity Fund, should not have the same stocks as one investing in smaller or mid-sized companies like the State Farm Small/Mid Cap Equity Fund. The same could be said of a mutual fund that invests primarily in foreign stocks compared with a domestic stock mutual fund.

You should know that different objectives does not necessarily mean different underlying securities. The State Farm Equity Fund may have a number of the same stocks found in the State Farm S&P 500 Index Fund because both invest in the stocks of large companies. Purchasing shares of both funds may not offer the diversification you are seeking.

By distributing your investment among different types of stocks or bonds, you are less likely to be affected by the volatility of the different markets. If small company stocks are down, your losses may be offset by gains in large company stocks and vice versa.

Asset Allocation takes the concept one step further. By dividing your assets among the different asset classes, you are able to take advantage of a wide variety of investments. You can invest some assets in higher risk stocks while placing others in corporate or government bonds of lower risk.

It is important to note that diversification does not assure a profit or protect against loss in a declining market.

An example of asset allocation would be to purchase shares of a stock mutual fund along with shares of a bond mutual fund like the State Farm Bond Fund. Bonds and stocks will each have periods of highs and lows, but may not experience them at the same time. During periods when stocks are performing poorly, bond yields may increase.

You may also purchase shares of a money market fund, generally considered a lower risk than stocks or bonds, as part of an asset allocation strategy. Money market funds, such as the State Farm Money Market Fund, attempt to keep a share price of $1.00 and hold short-term investments like commercial paper, re-purchase agreements and negotiable certificates of deposit.

By dividing your assets among a number of investment vehicles with varying risks, you may lessen the affects of market volatility. As your goals change, your investments may also change to become more or less aggressive and assume more or less risk.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.  Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.

The stocks of small companies are more volatile than the stocks of larger, more established companies.

Investing in international markets involves certain risks not typically associated with investing in the United States including foreign currency fluctuations and economic or political risks.

It is important to note that there is market risk involved when investing in mutual funds, including possible loss of principal.

State Farm VP Management Corp Risk/Important Disclosures. State Farm Mutual Funds Prospectus. The State Farm College Savings Plan Enrollment Handbook (PDF 276 KB).

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AP2008/01/9826