Disaster-Proof Your Portfolio

I've got one word for you: "diversification."

Wait! Don't hit the "back" button on your browser just yet. We need to talk about your portfolio, specifically those investments in your IRA, 401(k), or other retirement accounts that keep you up at night.

In order to get some quality Zs, you need a solid asset-allocation plan -- meaning a portfolio with a bunch of investments that don't always move in the same direction.

To accomplish that, it all comes down to -- you guessed it -- diversification. Please have a seat.

Spread the Wealth

Think of portfolio diversification as having a bunch of prom dates lined up: If one turns you down, you're not completely crushed, because you've arranged for a backup date -- one you're pretty sure will be giddy at the sight of your powder-blue tux and seasoned moonwalk.

In investing terms, diversification works like this: Instead of investing all your money in one place -- say, putting 100% in small companies’ stocks, or keeping it all in cash -- the idea is to hold a mix of asset classes. A portfolio spread out among, for example, small U.S. stocks, large international stocks, bonds, and emerging markets offers a much smoother ride -- a bad run for one asset class can be offset by another that's having a bang-up year (or at least one that's not so bad).

Does that describe your portfolio? If not, it's time for an annual investment makeover -- or, in Wall Street-speak, it's time to rebalance your portfolio.

Bring Re-Balance to Your Portfolio

Rebalancing simply means buying and selling investments to minimize your exposure to risk. The concept is simple, but the execution can get complicated, particularly if you have multiple investment accounts (IRAs -- Roth and traditional, old 401(k)s, current 403(b)s, etc.).

At The Motley Fool, we're believers in four main rebalancing strategies:

• The Add-and-Subtract Strategy: The easiest way to rebalance is to do the dirty work when you invest new money or make a withdrawal. For example, if you have mostly domestic large-cap stocks in your portfolio, you might invest in some international funds or stocks with your next IRA contribution check. Doing just that may not be enough to fully rebalance your portfolio, however. If that's the case, also use one of the following strategies.
• The Mothership Strategy: If you have one account that contains the majority of your assets, lucky you: Concentrate on rebalancing in that account, particularly if it's a tax-advantaged account that doesn't charge commissions (e.g., an IRA invested in no-load mutual funds). Any smaller accounts that are outside your Big Kahuna "mothership" savings can stay invested as is.
• The Every-Portfolio-Is-an-Island Strategy: If you have several accounts that are of approximately equal value, treat each account as an individual portfolio. That means moving around the money within those accounts so that each portfolio has roughly the same mix of assets. To avoid getting sideswiped by fees, pay attention to the account's tax status.
• The U.S.-Large-Caps-in-Every-Pot Strategy: Chances are that U.S. large-cap stocks make up the biggest piece of your portfolio (as is the case with most investors). Given their size and volatility, this single asset class tends to grow or shrink way beyond its original allocation. If you've got many accounts, holding a position in large-cap U.S. stocks in each makes it easy to increase or decrease your exposure. Because they tend to be tax-efficient, it can also be one of the cheapest ways to right your ship.

Dayana Yochim sincerely apologizes for not getting the economy back on track since last month's disaster-preparedness drill. Although they're not handing out economic stimulus checks over at The Motley Fool, where Dayana's the consumer-finance guru, they are offering plenty of sound long-term money management strategies. And hugs. Lots of hugs.