There are plenty of things you have to do in order to save and invest effectively for retirement, from reinvesting your dividends to using your tax advantages. However, one of the simplest concepts is critically important to protecting yourself from declines while making your returns more consistent.
One of the most important adjustments you can make to your retirement strategy is to learn how to think defensively, and the best way to do this is not by investing in less risky assets like bonds, but to properly diversify and rebalance your portfolio.
A diversified portfolio means more than simply spreading your money out among a basket of stocks. You need to make sure the companies you invest in are different enough from one another to protect you from any sector weakness.
For a basic example, investing in Citigroup, Bank of America, and JPMorgan Chase does not make you diversified. Sure, you're somewhat protected if any one of these companies starts to do poorly, but what if the entire sector crashes like it did a few years ago.
And even though it may not be as obvious, watch out for companies that are linked together. For example, consider Best Buy and Intel. If computer sales began to struggle, both of these companies could suffer tremendously. It's impossible to invest in companies that are completely independent, but be aware of how your stocks are similar to one another and adjust accordingly.
Your allocations don't need to be perfectly even, but you don't want too much of your portfolio tied to any one industry.
Rebalancing: why it matters so much
It's not enough to simply diversify your portfolio, then forget about it for a while. Over time, different stocks will perform differently, and this can take your portfolio from diversified to not-so-diversified.
As an example, let's say you made five $10,000 investments a decade ago, in Apple, Pfizer, ExxonMobil, Caterpillar, and Wal-Mart. So, each made up 20% of your portfolio and you were well-diversified when you started.
Fast-forward ten years, and some of these companies have performed well and one (Apple) has been an absolute home run. As you can see from the chart below, your portfolio would have performed really well if you simply had left it alone.
The problem with this is now your portfolio is way too dependent on Apple, which would now make up more than 80% of your holdings. If Apple stock were to lose 50% of its value (hey, it's happened before), your portfolio's value would drop by more than 40%. Are you willing to risk a hit like that to your portfolio from a single stock? You shouldn't be.
Also, if the other stocks in the portfolio started to perform well, you would barely feel the effects. In our example above, even though Pfizer returned more than 40% over the past decade, it would now make up less than 3% of the portfolio, so any future gains would have a very minimal effect on your overall portfolio.
The action plan
Take a look at your own portfolio and ask yourself if your investments themselves are diverse enough. Once that's established, check if your exposure to any particular sector is too high. Especially check your best performing investments to see if they now account for a disproportionally high percentage of your portfolio. If it is, you may want to sell some shares of one investment and buy more of another in order to balance things out.
Remember, the goal of investing for retirement is to make consistent, stable returns, not to hit home runs and take risks. If one of your retirement stocks shoots through the roof, that's great, but there is nothing wrong with taking some of your gains off the table. It locks in your profits, while leaving you less susceptible to that company's future performance.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.