The various risks you take as an investor can be broadly categorized as either systematic or nonsystematic.
Systematic risk, or market risk, is characteristic of the entire market or a particular market segment. Because the market is inherently unpredictable, systematic risk always exists. There is always the chance that the entire market, or a particular market segment, will experience an economic downturn.
A strategic use of asset allocation can help limit systematic risk. For example, in the bond market, when interest rates rise, the value of previously issued bonds decreases, thereby decreasing their relative value compared with bonds currently selling in the market. When this happens, new investors will be attracted to the bond market because of the higher rates. However, the popularity of the bond market has a negative effect on the stock market because investors will tend to leave stocks for bonds, where they can get a higher return with lower risk.
When the opposite happens, as it inevitably does, and interest rates drop, investors tend to put money into stocks for their higher potential returns, driving stock prices up.
To take advantage of this regular pattern of market ups and downs, allocating percentages of your portfolio to both of these asset classes, and others, can help counter the negative effects of a decline in one asset class and let you take advantage of gains in the other.
While asset allocation helps mitigate systematic risk, diversification can help alleviate nonsystematic risk.
Nonsystematic risk is based on unpredictable factors, like poor management decisions within a company or the introduction of competitive products. Because nonsystematic risk is based on the performance of an individual company or groups of companies, diversifying your portfolio by investing in a variety of companies within each asset class or in mutual funds within that class can help counteract nonsystematic risk. If you invest in more than one company, or in a mutual fund, your portfolio will be better protected against the adverse effects of one single company's failure.
Investors should consider the investment objectives, risks, charges, and expenses of mutual fund carefully before investing. A prospectus contains this and other information about the fund and is available through www.scottrade.com or through a Scottrade branch office. The prospectus should be read carefully before investing.