Pension plans provide a savings plan for employees that can be used for retireme

Question

Pension plans provide a savings plan for employees that can be used for retirement. The amount of money in the fund grows in four ways: (1) new contributions by the employee, (2) new contributions by the employer on behalf of the employee, (3) dividends or interest earned by the fund due to its investment in equity or debt securities, and (4) appreciation in the values (capital gains) of the securities in which the fund has invested. In aggregate, most of the contributions come from the employer. Pension funds are major investors in stocks, bonds, and various types of loan packages such as mortgage-backed securities.

What role do you think insurance companies play when it comes to pension funds and financial planning?

Explain the differences between diversification and asset allocation.

Which is more important in portfolio management?

Explanation / Answer

Astute investors realize the appeal of finding investment options that do not move in step with one another. Over time, we expect the stock market to increase in value, albeit with short-term fluctuations. Ideally, it would be great to identify an investment that increased in value when stocks faltered which would smooth out the volatility in a portfolio.

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.

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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

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