Money Girl Guest Post: A secret weapon to protect your investments.

Laura Adams is the blog writer and podcast host of “Money Girl’s Quick and Dirty Tips for a Richer Life.”

The key to being a successful investor is to minimize risk and to maximize reward. Easier said than done, right? So how can you accomplish this goal? One major way is by using asset allocation and diversification. Many people believe they’re the same thing; they’re not. I’d like to tell you how they’re different and give you a secret weapon to make sure your investments are better protected by using these important principles.

What do they do?
Asset Allocation lays the foundation for having a well-balanced portfolio. It means that your portfolio contains a mix of different asset classes to help reduce risk. Instead of owning just stocks, you would spread your investment dollars over more types of assets, such as cash, bonds, real estate and commodities.

Diversification goes one step further. It manages risk more closely by drilling down within each asset class, spreading the risk out among multiple investment categories. For example, owning large-cap stocks and small-cap stocks is less risky than owning stocks in just one of those categories.

Why does it work?
Investing in combinations of asset classes that aren’t related to each other will help you improve your returns and limit your losses because each class has its own economic cycle, level of volatility and risk. When your portfolio includes the right blend of asset classes and diversification, you’re less exposed to risk and thus more likely to get higher total returns.

So what’s the right mix?
It depends on your time horizon and tolerance for risk. Here’s a rough guideline you can use: subtract your age from 100, and that number is the percentage of stock to have in your portfolio. For example, if you’re 40 years old, you might consider holding 60% of your portfolio in stocks. The remaining 40% would be in various other asset classes such as bonds, real estate and cash.

Keeping with that example, if your portfolio is worth $100,000 and your stock allocation goal is 60%, you would try not to own more than $60,000 in stocks. However, if your stocks grow, you could find that your portfolio becomes too stock-heavy for comfort. You would want to sell off some stock and invest the money in other asset classes. Since your investment valuations are always changing, your portfolio should be rebalanced at least once a year to keep all your asset classes in proper proportions.

Sound too complicated? If so, don’t worry, there are mutual funds and exchange-traded funds (ETFs) that can come to your rescue. Most fund companies offer a category of products called life-cycle funds, which are also known as target-date or age-based funds. You choose the fund with a target date that matches when you plan to access the money. Target-date funds automatically rebalance to achieve growth in the early years and capital preservation in the later years. If you want to keep your money protected with minimal effort, a life-cycle fund is more than a secret weapon, it’s the bomb!

Now there’s no excuse. Your money can be well allocated and diversified by putting it in just one investment vehicle – and that makes meeting your long-term financial goals easier than ever.

For more tips from Laura Adams, connect with her at quickanddirtytips.com, on Facebook, or on Twitter.

Tags: Assets, Diversification, Investing, portfolio