Asset Allocation & Diversification
While it's true that nothing is risk free in the financial world, there are things mutual fund investors can do to help manage the level of risk, such as using Asset Allocation and Diversification to help create a more balanced portfolio. When a portfolio includes a balanced range of investment vehicles – some with limited risk, some with moderate risk and perhaps some considered higher risk – no single investment dominates.
Two terms you'll hear when looking for an investment strategy are "diversification" and "asset allocation." While they may have similar meanings, they are different approaches to investing.
Remember the old adage, "Don't put all your eggs in one basket"? That's asset allocation – spreading your assets across asset classes. By dividing your assets among the different asset classes, you're able to take advantage of a wide variety of investments. For example, stocks, bonds, or cash equivalents – each has advantages and drawbacks. You can invest some assets in higher risk stocks while placing others in corporate or government bonds, which are lower risk. Asset allocation does not assure a profit or protect against loss.
Asset Allocation Example
An example of asset allocation would be to purchase shares of a stock mutual fund like the State Farm Equity 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.
By dividing your assets among a number of investment vehicles with varying risks, you may lessen the effects of market volatility. As your goals change, your investments may also change to become more or less aggressive and assume more or less risk.
By distributing investments among a variety of securities within the same asset class, you may be less likely to be affected by the volatility of the different markets. For example, if small company stocks are down, your losses might be offset by gains in large company stocks.
One way to diversify a portfolio is to purchase shares of three or four stock mutual funds with different objectives. Each mutual fund offers a diverse portfolio, but you can get even more diversification by purchasing shares of funds with differing objectives. When objectives differ, the chance of two or more mutual funds holding the same stocks is less.
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 small- 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.
Different investment objectives don't 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're seeking.
By distributing your investment among different types of stocks or bonds, you're 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.
Investing involves risk, including potential for loss.
Diversification and Asset Allocation do not assure a profit or protect against loss.
The stocks of small companies are more volatile than the stocks of larger, more established companies.
Foreign investments involve greater risks than U.S. investments, including political and economic risks and the risk of currency fluctuations.
Bonds are subject to interest rate risk and may decline in value due to an increase in interest rates.
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