Quizmaster, Doug Hutchinson, presents his quiz for the month. This time the topic is 401(k) diversification. Keep reading to find out if Gina is going down the right path with her strategy.
Consider this scenario:
Your friend Gina has started a new job and she is reviewing investment options in her new 401(k) plan.
"My new retirement plan offers us 10 different investment options so I'm going to put 10% of my portfolio into each of these options. I'm spreading out my risk equally across different strategies. I think that the best and safest way to invest my retirement account."
Does Gina have a good plan to manage her new retirement account?
Solution:
Gina is using the "1/N diversification strategy," which may not lead to an optimal allocation for her portfolio. Given multiple options, investors will sometimes simply divide contributions equally among all of the options. If there are 5 options, they'll put 1/5 (20%) in each option. If there are 10 options, they'll put 1/10 (10%) in each option and so on.
The 1/N strategy leaves investors with an asset allocation that is dependent on the structure of their retirement plan. If the plan offers 5 stock funds and 5 bond funds, the 1/N investor will have a 50% equity/50% bond allocation. This allocation may or may not be appropriate for that investor. Moreover, if the plan offers 10 options and 3 of them happen to be U.S. Small Cap options, the 1/N investor will have a 30% allocation to U.S. Small Cap equities. This allocation may or may not be appropriate for that investor.
Gina seems to understand that she will benefit from diversification, but she is probably not allocating her portfolio in an ideal fashion. Gina should take into account her goals and risk tolerance when building a portfolio. Her 1/N diversification strategy is entirely dependent on the menu of investment options in her retirement plan. She may end up with an appropriate allocation by chance but her complete reliance on the 1/N strategy is not optimal.
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This quiz is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.
