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What is diversification and asset allocation?
Diversification can be summed up with the familiar phrase: "Don't put all your eggs in one basket." Including different types of investments in our portfolio may help reduce our losses if one type—stocks, for example—take a hit when other investments like bonds remain steady or go up. We achieve diversification through a process called asset allocation, which simply means figuring out how funds will be spread among different types of investments, such as stocks, bonds, and cash. Diversification may reduce risk, but we also want to earn a return, and so we need to strike a balance between risk and reward. Lower risk investments carry less chance of a loss but typically provide lower returns.
Understanding your risk tolerance
This tool illustrates the tradeoff between risk and reward that lies at the heart of investing. Pay close attention to the "Worst 12 months" figure in the lower right. Would you be comfortable if your investments lost that much in a year? Would you change your investments or stay the course?
|Large Cap Blend||29%|
|Large Cap Value||0%|
|Small Cap Blend||10%|
|Historical 15 year returns|
|Best 12 months (2004-2018)||+36.36%|
|Worst 12 months (2004-2018)||-28.40%|
|Average 12 months (2004-2018)||+6.25%|
This is what investment advisers mean by risk tolerance: it's about how much risk is appropriate and comfortable for you. Keep in mind, your risk tolerance will likely change over time as your age, life circumstances, and financial situation change.