As an investor it is vital to not have all your eggs in one basket. That is why asset allocation and diversification are important strategies to help you manage your risk to ultimately reach your goals.
But asset allocation and diversification are two different, yet similar, strategies. You could have good asset allocation, but poor diversification – and vice versa. To maximize the potential of your portfolio, you should employ both strategies.
What Is Asset Allocation?
First, let’s start with what asset allocation is. This strategy is where you invest in different asset classes. The idea behind asset allocation is simple; because all investment vehicles are different, you can balance your risk/return within your portfolio by spreading it among different asset classes.
Why Is Asset Allocation Important?
Asset allocation is important because each type of asset carries a different potential for return and level of risks. They also do not all respond to the market forces in the same way. For example, if the stock market is booming, another asset may be declining. If there is a downturn, one type of asset will not destroy your entire investment portfolio.
The Five Asset Classes
There are three main asset classes and two alternative asset classes that you should have as part of your portfolio.
Equity/Stocks have historically provided higher average returns than other investments. Although it is important to remember past performance does not guarantee future results, and the stock market is typically more volatile than other investment vehicles.
Bonds are less volatile than equity/stocks, but they do not offer as much growth potential. Bonds offer fixed interest payments, which provide regular income from your investment.
Cash Alternatives like certificates of deposits and money market funds have low potential for growth but can be accessed easily. Of the three main asset classes, they carry the least risk.
Commodities including metals, energy resources, and beyond come with varying levels of risk. They are an alternative investment vehicle that you can receive high returns if you properly trade them.
Real Estate is another alternative asset class. You can invest in real property, including generating income from monthly rentals or price appreciation. You can also invest in real estate through real estate investment trusts (REITs).
Asset Allocation Strategy
Depending upon your age and risk tolerance, you might have a different asset allocation strategy. However, many investors determine how much to invest in equities by “The Rule of 100.” With this strategy, you subtract your current age from 100. The result is the percentage of your portfolio that you should invest in stock.
If you are 25 years old, you would take 100 – 25 = 75, meaning it is suggested to invest 75% in stock. However, when you turn 70, it would only be suggested to invest 30% in the stock market. The older you get, the more you should allocate your assets to less volatile asset classes.
What Is Diversification?
Now that we’ve examined what asset allocation is, we should explore diversification. This strategy is where you invest in different investments within each asset class. The idea behind diversification is to find the right balance of investments within each asset class to further reduce your risks.
Why Is Diversification Important?
Diversification is important to increase your odds on your portfolio’s success. While no one can predict with certainty what asset is going to provide the biggest return, allocation of your investment across various industries and categories can help mitigate some risk.
Different Types of Risk
When you invest, you are faced with two main types of risk: systematic (commonly called market risk) and unsystematic (commonly called diversifiable).
Systematic risk reflects the risk of the entire market as a whole. The common risks come from political instability, inflation rates, exchange rates, interest rates, war, and other outside factors. This type of risk is not specific to any industry or company, so it cannot be eliminated.
Unsystematic risk is industry, company, economy, market, or country specific. Because you can diversify across these various sources, you can limit your exposure to risk.
Diversification Used to Lower Unsystematic Risk
Diversification will only help your unsystematic risk. When you have a well-diversified portfolio across multiple companies, industries, and markets, the strong performance of some investments can compensate for negative results from poor performing investments.
Ways to Diversify
When you begin looking at ways to diversify your portfolio, you should consider the following:
Industries. When you invest in various companies across multiple industries, they tend to not have as much market fluctuation correlation with each other.
Type of investments. You should look at the different diversification options between the various asset classes. You should not just diversify stocks. In fact, you should diversify all asset classes including your bonds, cash, and the like.
Risk levels. Diversify your investment with vehicles that have dissimilar levels of risk.
Foreign markets. You can invest in domestic and foreign markets as they have less correlation with each other.
What Are the Key Similarities & Differences?
Asset allocation and diversification are two important strategies that help distribute investments to minimize the risk of your portfolio. Both strategies can continue to be reviewed and reworked to ensure you are maximizing the potential of your future wealth.
While both these strategies help minimize your portfolio’s risk, they are different strategies. Asset allocation focuses on spreading your investments across multiple asset classes. Diversification then focuses on balancing the assets within each asset class to further minimize your risk.
Additionally, asset allocation tends to be based on other factors including age, income needs, and risk tolerance, while diversification is focused on industries, investment types, and risk levels.
What Is Asset Allocation & Diversification Used for?
Investing is unpredictable. While it would be ideal to have a crystal ball tell you exactly where and how to invest your money, that unfortunately is not reality. Instead, the market is unpredictable and economic factors are continually in flux. Asset allocation and diversification can help you manage the risks of an unpredictable market.
Can Investors Use Both Asset Allocation & Diversification?
Investors can, and should, use both asset allocation and diversification strategies. While neither one can guarantee profit or protect fully against losses, a well-allocated and properly diversified portfolio can help put you on the right track for competitive returns while you reduce your market risk.
Minimize the Risk to Your Portfolio
When you began investing, you likely began with the end in mind. Even if you did not have a 100% clear picture of where you wanted your future wealth to be, your goal was to continue to expand it.
If you do not have a properly allocated or diversified portfolio you could be missing out on important growth opportunities. Working with a trusted financial advisor can help provide you with asset allocation and diversification strategies to help you get the most out of your investments.