Traditionally, there are several asset categories that have this type of relationship: stocks and bonds, US stocks and international stocks, large cap stocks and small cap stocks, etc. Over time, the strength of the correlations between these asset classes has varied. To avoid having all your investment eggs in one basket, it is important to have appropriate asset allocation and diversification strategies, and to understand the difference between the two.

Asset allocation is the most basic and important component of investing. An asset allocation is simply the percentage of your portfolio invested in stocks, bonds, and cash. Your asset allocation is the primary determinate of how risky your investment portfolio is. Stocks are the most aggressive investment, bonds are a middle-of-the-road option, and cash is the safest way to invest your money. Of course, the higher the risk of your portfolio, the higher the return you should expect.

Asset allocation, not market timing or asset selection, will account for approximately 92% of your investment return. An appropriate allocation that matches your risk tolerance will help you obtain the rate of return necessary to achieve your investment goals while limiting volatility so you can sleep at night.

A well-devised asset allocation does not ensure you are appropriately diversified, however. For example, if you have determined that you should have 60% of your investments in stocks, you shouldn’t invest that full 60% in one stock. In fact, you shouldn’t have the bulk of your investments in the same asset category (large cap, mid cap, small cap, international, growth, or value).

To be adequately diversified you should have representation in each of the major asset categories. Further, you should own at least 50 stocks in each category. (Owning a large amount of your employer’s stock in your 401k is a common way of breaking this rule.) This steps will prevent your portfolio from plummeting due to the performance of one under-performing stock.

Diversification applies not only to stocks, but also to the bond side of your portfolio. Many people invest solely in U.S. corporate bonds, but they should be rounding out their portfolio and reducing risk by also investing in U.S. Government bonds and international bonds.

If done properly, determining an asset allocation that is right for you will help ensure your portfolio is correctly positioned on the risk-return continuum. Diversification is an additional step that spreads your investment bets across various asset classes to prevent your entire portfolio from suffering losses all at once. Incorporating both strategies will lessen the volatility in your portfolio and increase your chances of reaching your investment goals.

Back in February, the difference in yields on the 10-year and two-year treasury notes hit 2.929 percentage points, which was a record high. The yield curve is now at 2.16 percentage points, which is still quite high by historical standards. This is a key reason why many economists see little chance of a double dip recession.

Also, please email lon (lon@networthadvice.com) if you have a financial question you would like him to address in an upcoming issue.

401(k)

First, determine whether your employer’s 401(k) has a match. For instance, many 401(k)s match your contributions dollar-for-dollar up to 4% of your salary. A match like this is simply too beneficial to resist. Think of it this way — we hope to obtain a rate of return of 8 to 10 percent on our investment portfolio, but if our employer offers the match described above, we are guaranteeing ourselves an immediate 100% return on our investment.

However, depending on circumstances, it may or may not be wise to contribute more to your 401(k) than your employer will match, and if your employer offers no match, there are other factors that need to be considered.

Consumer Debt

I frequently see individuals with credit card debt with interest rates between 20 and 30 percent. If we are not getting an additional match from an employer on retirement savings, does it make sense to invest in the market where we hope to obtain a 10 percent return when we can essentially guarantee ourselves a rate of return of 20 to 30 percent by paying off these debts? One would be better off paying down debt with these high interest rates before investing elsewhere.

Emergency Fund

After paying off consumer debt but before investing in the marketplace, I suggest you establish an emergency fund, which should consist of enough money to pay for three to six months worth of spending. If your household only has one source of income, a six-month reserve is probably more appropriate. Having this reserve will protect you in the event of a job loss or medical emergency.

Other Retirement Planning

After paying off expensive consumer debt and having an appropriate emergency fund, you should shift your attention back to retirement planning, regardless of whether your employer matches 401(k) contributions. In fact, your employer’s 401(k) may not even be your best option. Investors can frequently build a more diversified a technically sound portfolio via the thousands of investment options available within an IRA. Consequently, in many cases, it makes more sense to contribute to an IRA than to a 401(k). Keep in mind this does depend on your personal circumstances.

Mortgage

People frequently wonder whether they should attempt to quickly pay off their mortgage. This often comes down to your tolerance for risk. Again, the market has historically provided even a conservative portfolio with an annualized rate of return of 8 to 10 percent. If your mortgage rate is only 5 to 7 percent, it likely makes sense to invest rather than pay off the debt. This conclusion is exaggerated when we consider that the interest on our mortgage is tax deductible. However, if you simply can’t be comfortable investing in the market, paying down the mortgage may be acceptable way of essentially guaranteeing yourself a rate of return: your mortgage rate adjusted for the loss of a tax benefit.

Note: This list of priorities is always impacted by your personal situation. I recommend speaking to a fee-only financial planner about your circumstances before taking action.

Back in February, the difference in yields on the 10-year and two-year treasury notes hit 2.929 percentage points, which was a record high. The yield curve is now at 2.16 percentage points, which is still quite high by historical standards. This is a key reason why many economists see little chance of a double dip recession.

Morningstar found that in aggregate, low-cost funds had better returns than high-cost funds across all asset classes during various periods from 2005 through March 2010. For example, domestic stock funds in the cheapest quintile in 2005 posted average annualized returns of 3.35% over the ensuing five years, compared with average returns of 2.02% for funds in the most expensive quintile.

1. Cost

If your ex-employer is small, you are probably paying higher-than necessary fees and should get out. Keep in mind that more and more employers are charging ex-employees account-maintenance fees ranging from a few dollars per year to more than $100 per year. Rolling funds to an IRA or Roth IRA will avoid these fees and may provide access to less costly investment options.

2. Investment Choices

Many 401(k) plans have a limited number of investment options. There are certainly advantages to rolling funds into an IRA with 23,000 mutual fund options rather than leaving the funds in a 401(k) with a dozen options. More choices allows you an opportunity to find the best offerings in each asset class. Additionally, a 401(k) may not have any investment options in certain asset categories. For instance, the IHC 401(k) plan, a retirement plan many people in Utah participate in, does not have a single mid-cap stock investment option. This shortcoming can be addressed in an IRA.

3. Account Access

Be aware that 401(k)s and IRAs have different withdrawal rules. With some exceptions, assets in traditional IRAs need to be left alone until you turn 59.5 to avoid the 10% penalty on early withdrawals. Some 401(k)s, however, allow you to take penalty-free withdrawals at age 55 or older when you leave your job.

4. Required Minimum Distributions

Both 401(k)s and IRAs require the owner to begin taking withdrawals no later than age 70.5 (after all, the government wants its cut). However, Roth IRAs are not subject to RMDs. When you convert retirement dollars to Roth dollars, you pay taxes on the converted amount, but all withdrawals from the account are tax-free. Thus, the government doesn’t require you to take distributions because it has already been paid.