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All investments involve some level of risk because they can incur a loss. While it’s impossible to eliminate risk entirely, you can adjust your investment strategies to align with your financial goals. If you’re new to investing, you’re probably aware of some of the basic principles of sound investing but might be unsure what it all means. Keep reading to learn more about asset allocation vs. diversification, and how you can implement these two strategies to achieve your investment goals
Asset allocation and diversification: Foundation of Investing
Asset allocation and diversification are two concepts that you’re likely to hear about over and over again. They are the essential strategies you can use to build an investment portfolio. How you allocate your assets to align with your investment goals determines the overall performance of a diversified portfolio.
- Asset allocation refers to the act of investing in different asset classes. This strategy rebalances based on the changing market performances and an investor’s risk tolerance, time horizon, and goals.
- Diversification is the approach of spreading out risk by allocating investments in various holdings in the same asset class.
- Asset allocation and diversification are important strategies investors implement in an investment portfolio to reduce risk and possibly increase returns over time.
- Both strategies aim to maximize potential returns while minimizing risks.
What Is Asset Allocation?
Asset allocation is an investing strategy that outlines how investors should distribute capital between different asset classes in a portfolio. Generally, investors choose from a variety of investment types, including bonds, stocks, commodities, cash, and real estate. The process of picking a mix of assets to hold in a portfolio may vary from one investor to another.
The primary objective of asset allocation is to maximize expected returns while minimizing potential risks. The asset allocation strategy that works best for you depends on these three factors: risk tolerance, time horizon and long-term investment goals. A careful analysis of these factors can help you make prudent decisions suitable for your needs.
You can measure asset allocation in percentages of the asset classes. Using an asset allocation strategy, you can invest in different proportions of asset classes in your portfolio. For example, you can invest 60% in stocks, 20% in bonds, 10% in cash alternatives, 5% in international stocks and 5% in emerging markets.
Typically, everything that involves money is risky — certain asset classes will perform differently depending on how they respond to market forces. The goal behind asset allocation is to identify those factors and allocate assets appropriately.
Types of Asset Allocation
Here is a closer look at the classes of assets you can consider when using asset allocation:
- Stocks: Also known as equity, a stock represents ownership. When you invest in a stock, you’re purchasing ownership in that company. Stocks are the most volatile category of asset classes but offer the greatest potential for long-term growth.
- Bonds: A bond represents a loan made by an investor to a borrower, typically a government or corporation. In return for this loan, the issuers of bonds pay interest throughout the life of the bond. Bonds are generally less risky than stocks but have a slower opportunity for growth.
- Cash: Cash — including certificates of deposit, savings, and treasury bills — is the least volatile class of assets but offers the least return. The only problem with cash equivalents is the risk of inflation, which can overturn investments over time.
There are also alternative asset classes, such as real estate and commodities. Investments in these categories have their own risks. It is crucial to understand the risks involved in each asset class before you make any investment.
What Is Diversification?
If you’re familiar with the phrase “don’t put your eggs in one basket,” you have a basic understanding of diversification. The “eggs” are your money and the “basket” are your investments. Diversification involves spreading your money across various investments, hoping that when one investment performs poorly, the others will make up for the losses.
Diversification is another concept that is closely associated with asset allocation. It is the process of allocating investments across various securities in an asset class to spread out the risk. The mix of assets you choose to invest in each asset class can affect your potential returns.
The Primary Goal of Each Strategy
The primary goal of diversification is to lower the risk in case one of the investments loses money. For instance, if you decide to invest in stocks, you could diversify your portfolio by allocating capital to different stock market sectors, including technology, healthcare, energy, and consumer discretionary, among others. But if you focus on one industry sector, you won’t have a diversified investment portfolio.
You could also choose to include stocks of different company sizes in the same portfolio — for example, 60% in large-cap stocks, 30% in mid-cap stocks and 10% in small-cap stocks. The more you diversify, the better.
Navigate the Stock Market volatility
The concept of diversification can help you navigate the stock market volatility amid ever-changing market conditions. However, it can be intimidating if you have little understanding of the stock market. Working with an investment advisor or even investing with a robo advisor can help you diversify your portfolio based on your financial goals.
Here are some of the advisors that can help you diversify your portfolio:
Asset Allocation and Diversification Commonalities
- Asset allocation and diversification are closely associated strategies that investors use to achieve long-term investment goals and manage market volatility.
- While asset allocation is how you divide your investment dollars across several asset class categories, diversification is the number of holdings within these asset classes. How you choose those assets can affect your asset allocation strategy as well as diversification.
- Both strategies aim to maximize potential returns while minimizing risks. Through effective asset allocation and diversification, you can lower overall portfolio risk. Even though you cannot eliminate risk with these strategies, they can help you smooth out some of the bumps in your investment portfolio.
What Are the Differences Between Asset Allocation and Diversification?
- Asset allocation and diversification are two terms often used interchangeably. Although both concepts may sound similar, they are different but related strategies.
- Asset allocation is the way assets are distributed within your portfolio. The idea of asset allocation takes a great deal of time to build. On the other hand, diversification represents the number of investments in the same asset class in a portfolio.
- Typically, diversification is allocating capital across several securities in the same asset class — the more number of holdings in an asset class, the more diversified your portfolio is. By diversifying in various investments, you can minimize the potential downside when one or more holdings perform poorly.
Every investment has some level of risk. Depending on the market forces, some may perform better and others worse. While asset allocation and diversification cannot guarantee a profit or protect against losses, each can reduce the exposure to risk that results from changes in market conditions. Effective asset allocation and diversification strategy can reduce portfolio volatility.
Implementing Diversification and Asset Allocation Strategies
Asset allocation and diversification strategies work hand-in-hand toward your investment goals. Asset allocation is how you divide your capital among different investment categories, including stocks, cash equivalents, bonds, and other types of investments. The division into the various asset classes depends on your risk tolerance, age and goals. But, if you don’t diversify your portfolio, the risk of loss is high. This is where diversification comes in. Diversification is the technique of spreading your investments across different securities within each asset class.
For example, when you allocate your money to stocks, you should have different types of stocks, such as large-cap, small-cap, and international stocks. You can diversify further by investing in different industries within the sectors. Your ultimate goal is to reduce the overall risk and maximize the expected return.
Portfolio Analysis & Rebalancing
Over time, asset allocation can shift from its original allocation due to the changing market conditions. In such cases, it’s time to rebalance your portfolio to an asset mix that reflects your investment goals, the amount of risk you’re comfortable taking, and expected returns.
Rebalancing is the process of restoring your portfolio that has shifted from your target asset allocation. You can rebalance your portfolio by selling high performers and directing the proceeds to other investment options that have not yet experienced such growth.
The Bottom Line
Asset allocation and diversification are great concepts that play a critical role in learning to invest. A properly allocated and diversified investment portfolio can help you mitigate risk, reduce overall volatility and achieve financial goals.
You may want to consider working with an investment advisor like Farther, which can help you devise an asset allocation strategy and show you how to diversify your portfolio. Before you decide to work with these professionals, do your due diligence by checking their credentials and experience.