Investing for your future: Diversification, asset allocation, lifestyle and lifecycle funds

By Tom Wyatt, JD CFP® CLTC

I still remember the shirts that the finance department sold when I was in college. They were all grey, and had one simple word, printed in bright red – “Diversify.” At the time, I understood the textbook definition and the effect that diversification has on a portfolio’s standard deviation, but no real world experience regarding diversification.

Here we are, “a few” market cycles later, right in the middle of what the pundits politely call a “market correction” and the importance of diversification and appropriate asset allocation seems to be a hot topic again. 

Proper diversification allows you to reduce the risk of their overall portfolio, while still remaining invested in securities which can provide strong long-term growth. The idea is simple – by holding a diverse group of investments, if any one investment falters for any reason, your entire investment portfolio does not go down with it (at least not at a 1:1 correlation). 

There are many types of diversification to consider:

• Among companies within a single industry
• Among many industries
• Among many geographic regions
• Among countries
• Among various types of securities (think stocks vs. bonds, vs. certificates of deposit)

The good news is that diversification today is easy: for many of today’s investors, 401(k) plans (which are the bulk of many people’s investible assets) offer a wide range of investment options, all of which are mutual funds or they’re made to look and function like mutual funds.

Diversification among companies, industries and geographic regions is typically done for you, if you are investing in most mutual funds. Mutual funds hold many various securities, from wide ranging industries and areas of the country. If you need more international diversification, you can pick up an international or global fund. If you want more bond exposure, pick up a bond fund or “balanced” fund. Have a lot of large cap (think S&P 500 or DOW), then maybe some small cap is in order. 

Most good 401(k) plans offer options filling all these needs. If yours doesn’t, take it up with HR—plans should offer their participants access to most major types of investment markets. 

Asset allocation is a spin on diversification that attempts to create a good, diversified mix of investments, to maximize one’s return and minimize the volatility (indigestion factor) involved with being an investor. In other words, it tries to fit a portfolio to an investor’s risk tolerance. 

Most financial planners and investment planners use a “risk profile questionnaire” early on with a new client.  A risk profile questionnaire requires the client to answer a few questions that are deliberately created to tell the advisor how much risk the client is comfortable with. The advisor then puts together a portfolio – let’s say 60% stocks, 40% bonds. That mix is the client’s asset allocation. The next step is for the advisor and the client to work together, and determine which investments will make up the 60% and the 40%.

Lifestyle funds take a similar approach to asset allocation – except instead of asking any questions, they simply state an objective or investment style in their title – such as the “Aggressive Growth Fund.”  An investor in this fund doesn’t need to diversify by also selecting other funds – because this lifestyle fund already holds many different mutual funds inside it. There are lifestyle funds running the gamut from conservative to ultra-aggressive, and they are all designed to be a “one-stop shop” for investors who don’t want to take the time to do their own asset allocation model.

Lifecycle funds try to make it one step easier. They only focus on when the client will be taking the money out. They assume that if someone has a long time horizon for this investment, they are comfortable with losses over the short-term, if it means that they may have a higher return over the long-term. So if someone is investing for retirement in the year 2030, then a “lifecycle 2030 fund” is the right one for that investor. The fund makes all the choices about how much risk and volatility is appropriate. This “lifecycle 2030 fund” will likely be fairly aggressive, as we are talking about an investment time horizon that is 20+ years away. By the same token, if someone is approaching retirement or in retirement, then a “lifecycle 2010 fund” or “retirement income fund” would probably be a better fit. 

These lifestyle and lifecycle funds make diversification and asset allocation a lot easier. However, there may be a price to be paid (literally) for all this convenience. Lifestyle and lifecycle funds are mutual funds. There are trading costs, manager fees, etc. required to run them. These fees are disclosed as an “expense ratio” and in the fine print of the fund prospectus. All mutual funds do this. The problem is that many lifestyle or lifecycle funds are investing in other mutual funds, which may also charge these fees and expenses. The net effect is that the client may be getting charged two levels of fees for the convenience of investing in lifecycle or lifestyle funds. In addition to this fee issue, there are questions about what research and decision making is going into the underlying funds (the funds that the lifestyle or lifecycle fund invests in). Are they simply chosen because they are owned and run by the same fund company, or are they really the best available in the given category? 

To my knowledge, not all lifestyle and lifecycle funds have these problems. My recommendation is to ask questions and investigate this issue before blindly investing in these types of funds. If you have further questions, request a prospectus (or get online and download the prospectus) or ask questions of your advisor. 

Thomas D. Wyatt, JD CFP® CLTC is the retirement plan consultant for The Ohio Society of CPAs retirement plan. Jacob, Haxton & Boord LLC (JHB) is a Worthington-based retirement plan consulting firm and third party administrator for all types of retirement plans. To contact Tom or JHB, please call 614.888.1005, ext. 133.  

Tom is a Registered Representative of Park Avenue Securities, LLC. (PAS) 120 East Fourth Street Suite 1500, Cincinnati, OH 45202. 513.579.1114. Securities products/services and advisory services are offered through PAS, a registered broker/dealer and investment advisor. Tom Wyatt is an agent of The Guardian Life Insurance Company of America (Guardian), New York, NY. PAS is an indirect, wholly owned subsidiary of Guardian. PAS is a member of FINRA, SIPC.

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