Diversifying your 401(k) is important to any investor today, says Robert Brokamp, a senior advisor from the Motley Fool. He’s willing to share the “Fools Rules” for asset allocation.
The first rule is this: if there’s any money that you’re going to need in the next few years, then you need to keep it in
cash. Anything that’s absolutely necessary shouldn’t be risked, and investment always carries an element of risk with it. It’s important to keep those cash reserves safe from any kind of crashes, either in the stock market or in the bond market. This goes for any kind of immediate need you may have: if your child is about to enter college, for example, or if you yourself are nearing retirement. Always keep enough cash on hand to take care of your immediate needs, and remember that there may be circumstances that arise that you haven’t considered. You need to be prepared for things that are beyond your plans.
The second rule is this: know yourself. It’s important that you understand how much risk you feel comfortable with. This is what Brokamp calls your “risk tolerance.” How much up-and-down can you stand dealing with financially; how much can your portfolio demonstrate volatility before you start getting anxious? You may not actually have a sense of how much risk you can handle, but Brokamp offers an easy way to figure it out. He asks a series of questions that look at your past behavior to determine your attitude and future comfort levels.
When the stock market climbed by 50% between 2007 and 2009, what was your reaction? That’s an important measuring-stick. You may have responded by seeing it as a great opportunity, by jumping right in and buying more stock. Or did you do the opposite? Did you hold on to what you had, tried to just stay the course? Or, on the other end of the spectrum, did you sell stocks during that time?
Here’s the thing, he says: if you panicked when your 401(k) went down by 50%, if that kept you awake at night, if you were frightened and backed off, then your temperament isn’t one that’s comfortable with taking serious risks with your portfolio. Brokamp advises that you remove some of your 401(k) portfolio from the stock market and so something else with it—keep it in cash, or in a bond form. Remember the rule about what to do if you’re close to retirement? That goes here if you feel nervous about what your money might be doing: the same cautions apply.
Some rules of thumb
So remember what we talked about before: keep enough money that you’ll need over the next few years in cash. That’s wise. The flip side to it, of course, is that the other money, the money that you won’t be requiring over the next few years, is money that you can spend on stocks.
Here are Brokamp’s few rules of thumb for those investments: If you’re American and live in the United States, then invest three-quarters of the stocks in U.S. stocks and the other quarter in international stocks.
Divide the stocks into thirds, he advises. Once you’ve done that, put one-third into large-cap stocks, one-third into mid-cap stocks, and the final third into small-cap stocks.
As you think about your immediate needs, think also about your long-term needs. Your investments are for the
remainder of your life, and most healthy adults live well into their eighties, some into their nineties. You’re not just investing fort he moment of retirement; you’re investing to the moment of death. That makes a difference in the way you should be looking at all this.
You probably will be able to enjoy decades, not years, of retirement, and that takes a different mindset. But remember that for longer time horizons, stocks have historically been the best investment, and they continue to be.
Why not reap the benefits for yourself?