Is Your 401k Diversified?

Is Your 401k Diversified?

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Many investors saving for retirement who lost considerable sums of money in their 401K during the financial crisis of 2008 and 2009 are concerned if their 401K is diversified.

Most 401K plans offer a selection of funds that cover different asset classes. However, it's left to the 401K participant, you, to choose the amount to invest in each fund. It pays to know that how you allocate your wealth between the different fund offerings will materially impact your retirement lifestyle.

Diversification is an important aspect of your allocation decision because it lowers risk while allowing you to seek a higher return. Here, I discuss how to assess the diversification of your 401K.

Consider the meaning of diversification

There are various methods for measuring diversification that ultimately indicate how evenly your portfolio is proportioned across different investments. This isn't the best thing for an investor to focus on though. Many investors know that diversifying your wealth among 50 pharmicudical positions won't provide as much diversification value as positioning it across 50 stocks drawn from different industries and countries. Diversification and the benefit of diversification are measured differently. It pays to calculate the risk reduction obtained from diversification.

How does one measure risk?

Big movements in security prices are a primary risk faced by investors. How much security prices bounce around, and how quickly they do so-volatility, is how most financial professionals measure risk. To assess risk in a portfolio, you also have to examine how the prices of different assets within the portfolio move together over time- their correlation- because portfolio risk depends on correlation. When the prices of two or more assets move in tandem they are said to be highly correlated. When price fluctuations are relatively independent they lack correlation. All else equal, higher correlation means higher risk, and lower correlation means lower risk.

When assets or asset classes have high correlation, they are being driven by the same underlying events, whether political, economic or of some other type. Alternatively, asset classes with prices that move independently do not likely depend on the same events. You can ameliorate risk caused by events by investing in asset classes with low correlation. But if you don't measure correlation and use the result, you may end up with sizeable sections of your portfolio being impacted by the same underlying causes.

The financial crisis provides a memorable example

During the financial crisis, the correlation among almost all asset classes rose substantially. This happened because, in a rather complex way, the value of most securities became tied to a single event: the outcome of the real estate market. When the correlations across assets rose, the risk within 401K portfolios also rose, and when the markets ultimately collapsed, investors found that their portfolios were not well protected by diversification. Had investors (or their advisers) been monitoring the degree to which their investments became correlated they could have taken action to control the additional risk that crept into their portfolios as a result of rising correlations.

Consider the correlation in your portfolio

In summary, if you are concerned about the diversification of your 401K, examine the correlation of the in your portfolio. If your portfolio is loaded with assets that are highly correlated then your diversification value is low, because when one asset class falls, it is probable that they will all fall. You can lower your risk by allocating your portfolio among uncorrelated assets.

About the Author:
If you want to learn more about how to use correlation and volatility to diversify your portfolio click here: www.portfolioresearchllc.com
To view our Market Risk Meter, which measures correlation, and volatility of various asset classes click here: https://www.portfolioresearchllc.com/education/riskreport.aspx



Article Originally Published On: http://www.articlesnatch.com


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