Why it is Important to Diversify Your 401(k)
There are at least 20 million active employees in the US who are investing in 401(k) plans. As a result, the US has possibly the highest amount of capital investors on the globe. Although different countries have various retirement plans, what makes the 401(k) plan unique is that it links American citizens to the financial securities market.
Nevertheless, every market comes with a particular level of risk. If you’re investing in a 401(k) plan for retirement, you need to understand how crucial diversification is. Every investor wishes that the investments they make will always produce a high return on investment. However, the reality is very different, and sometimes investments can go wrong.
To explain the need for diversification of your portfolio, imagine a trader selling only raincoats in a particular region. This trader will only make money for half of the year because raincoats are only needed during the rainy season. During half the year, the rain is heavy, and during the other half the sun shines every day of the week.
To make money throughout the year, the trader will need to sell not just raincoats but also products like sunscreen, shades, and other things designed to protect humans from the sun. Although the explanation of diversifying a 401(k) is not as linear, the concept is still the same. Diversification protects your money in times of market downturn.
If you’re wondering how to diversify into precious metals, here is a great article on how to invest in gold with your 401(k).
What Is Asset Allocation?
Asset allocation is the most common form of diversification. When you place your money across several investment classes like stocks, bonds, gold, and cryptocurrency, you’re performing asset allocation.
Since it has been established that markets fall at one point or the other, you must also protect your overall investment from slipping. For instance, if the stock market is crashing and the entirety of your investment is in stocks, your portfolio will also experience a sharp downturn.
However, if stock prices fall and you’re invested in bonds as well, the value of your portfolio would remain roughly the same. This is because the bond and stock market are negatively correlated and have an inverse linear relationship. Simply put, as one falls, the other rises due to investor sentiment.
Although diversifying into stocks and bonds might slow down your portfolio’s growth, it protects you in times of an economic recession. Investors typically shift from stocks to bonds during bear markets since bonds are considered less risky. This leads to an uptrend in the bond market.
Real-Life Instances Explaining the Importance of Diversifying Your 401(k)
While you can diversify your portfolio within an asset class, it is less risky to do so across various asset classes. For instance, in the early 2000s, anyone who invested heavily in the tech sector of the stock market recorded significant losses. This is known as the dot-com bubble. It burst when tech stocks experienced a massive correction due to over-valuation.
In the same vein, stocks in the finance sector went down in price sharply after the subprime mortgage crisis. This occurred in 2008, and it resulted in the Global Financial Recession. If you were an investor placing all your eggs in the financial stocks basket, you’d have taken a big hit on your 401(k).
Placing your entire investment in a single stock is an even worse strategy. Essentially, you’d be relying on several factors like the integrity of the business managers, market sentiment, and a little bit of luck not to lose your investment.
For instance, if you were an investor that held only Amazon stocks during the dot-com boom, your investment would have been slashed by 16 times. In 10 months, Amazon’s stock dropped from $100 to around $6. While you have the benefit of hindsight to know that Amazon later became one of the most valuable companies, at the time, you’d have been panicked and most likely sold at a massive loss.
How to Perform Asset Diversification
Understand You’re Investing in the Long-Term
The first essential thing you need to understand is that you don’t need to make decisions when the market you’re invested in is experiencing a downturn. When you have a 401(k) fund, it’s supposed to last you for years after retirement. You need to have patience after you diversify your assets.
Similarly, you don’t need to rush into any market you feel is booming at a high rate. Long-term investors typically ‘forget’ their money in the markets and ignore fluctuations.
Your Investments Should be Made for Growth
You need to invest in equity mutual funds for your 401(k) to experience growth. Equity mutual funds track the stock market, which is by far the best form of investment over time.
Suppose you can ignore the flash crashes and bear markets. In that case, you’ll see that stocks have bested all other forms of investments while simultaneously beating inflation. Hence, the bulk of your 401(k) needs to be concentrated on the stock market.
Understand your Risk Tolerance Level
You must understand your risk tolerance level to determine how you’ll divide your 401(k) portfolio. While some investors are naturally risk-takers, others are risk-averse. Nevertheless, you need to take an optimal amount of risk suited to your personality.
If your 401(k) diversification decision gives you sleepless nights, you need to re-diversify.
Do Constant Reviews
At least once a year, you need to review your portfolio and decide if it is performing the how you want it to. If it isn’t, you might need to reassess your 401(k) diversification.
Your 401(k) will determine how well you get to live after retirement. Hence, there’s a prevalent need to understand how to diversify your 401(k) to protect against bear markets or sharp price drops.
Asset allocation translates to spreading your investment over different asset classes like crypto, bonds, stocks, and precious metals. To perform asset diversification, you need to understand that you’re going in for the long term. Then your investments need to be optimised for growth.
You need to understand your risk tolerance level and regularly review your 401(k) to determine whether you need to make modifications.