Virtually any investment professional will advise you to diversify your investment portfolio. However, determining the best mix of stock funds and bond funds isn't easy. Fortunately, with some rules of thumb and a basic understanding of risk, you can find out what stock and bond mix works for you.
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Diversified Investment Portfolio
A diversified investment portfolio allows an investor to optimize their returns, while ensuring that risk is kept at a level the investor can tolerate.
To create a diversified portfolio, many investors turn to mutual funds. Mutual funds are a single investment, which is in turn invested in numerous securities. Mutual funds are often set up to invest in a specific market sector or type of investment. For example, bond funds only invest in bonds, while stock funds only invest in stocks. Mutual funds can be more targeted such as those that invest only in government bonds or those that invest only in foreign stocks.
Creating a diversified portfolio is a two-step process. First, determine the proper mix of stock and bond funds for your portfolio and then choose the specific funds that fill each category.
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Portfolio Ratio of Stocks to Bonds
One of the most commonly cited rules of thumb regarding how much of your retirement portfolio should be invested in bonds involves subtracting your age from 100. The result is the percentage of the portfolio that should be invested in stocks, and the remainder would be invested in bonds.
The concept behind this rule of thumb is that the closer a person is to retirement, the more conservative their portfolio should be. Thus, a person who is 65, and very near retirement, should be investing more conservatively than a person who is 30 and has decades to go before retirement. The idea is that the younger person has numerous years to make up any losses caused by market swings, while the older investor has little or no time to make up for such losses.
For example, using this rule of thumb, a person who is 30 years old should invest 70 percent of their portfolio in equities and 30 percent in bonds. Conversely, a person who is 65 years old should invest just 35 percent of their portfolio in stock funds and 65 percent in bond funds.
Some experts suggest that this age minus 100 rule of thumb is too conservative, especially with many retirees living longer.
Another way to determine the perfect mix of stock funds and bond funds for a retirement portfolio is to use an asset allocation calculator. These tools are available online and offer different ways to calculate the proper investment mix. For example, the free asset allocation tool offered by Bankrate.com allows you to select not just your age, but also your risk tolerance, and even how you feel the economy will do in order to calculate a specific mix of stock and bond asset classes.
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The age-based rule of thumb for choosing how much to invest in stocks versus bonds is only used for retirement investing. Investment portfolios for other purposes would not benefit from using such a rule of thumb. Instead, investors should determine how long before they plan to access the funds within the portfolio. Again, the shorter the timeframe, the more conservative portfolio should be used.
Free calculators such as the ones offered by Bankrate.com and Forbes allow you to plug in a timeframe for your investments and can calculate the perfect mix of bond funds and stock funds for a portfolio. Shorter time frames will result in a higher allocation to bond funds, while longer time frames allow for a higher percentage investment in stock funds.
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Bond Funds and Stock Funds
While a good mix of bonds and stock funds could theoretically be achieved with just two mutual funds, even better diversification can be achieved by picking a selection of mutual funds that specialize in specific stock and bond markets.
For example, an investor might choose three bond funds, one dedicated to government bonds, one dedicated to high-quality corporate bonds and one that invests in high-yield bonds. Likewise, most investment professionals advocate investing the stock portion of a portfolio across funds that target specific sectors of the market. A common diversification strategy is to use stock funds that invest by size and then by location. For example, an investor might choose a small, medium and large cap stock mutual fund in addition to an international or foreign stock fund.
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Choosing mutual funds for any investment portfolio can be time consuming. However, it is time well spent. Morningstar offers a free, well-respected mutual fund research tool. Investors can input criteria they want in a mutual fund into the fund screener tool, which returns a list of mutual funds that meet the user's criteria. Using this tool, specific stock and bond mutual funds can be found and selected based upon the needs of the investor. Be sure to look at the long-term performance of each fund. A common beginning investor mistake is to put too much emphasis on the recent performance of a mutual fund.
Remember, once you have that perfect asset mix in your portfolio to review your situation on a regular basis. As you get older, you'll want to adjust your portfolio. Many experts recommend rebalancing your portfolio on a regular basis such as annually or semiannually.