"Asset allocation" and "diversification" are two important concepts that frequently raise eyebrows among new investors as they can be confused as interchangeable terms. Although asset allocation and diversification are frequently employed interchangeably, they represent two very distinct concepts.
Understanding asset allocation vs diversification will give you two of the most important concepts to make you a better investor.
What is Asset Allocation?
Asset allocation is the approach to the distribution of assets within your portfolio that matches your objectives and goals–where you put your hard earned money.
Such a distribution is determined by risk tolerance, age, asset base, income requirements, amongst many other factors. Asset allocation is usually expressed as a proportion of the asset classes in which your investments are held.
Whenever it comes to asset allocation– many new investors will involve themselves in different asset classes such as stocks, bonds, commodities, cash, crypto-currency, real estate, businesses, and even art. Asset allocation is the breakdown of how much you have invested in each of these different forms of investments.
For instance, when you first start investing you may allocate 100% of your money into exchange-traded funds, or individual stocks depending upon your risk tolerance. As you are approaching retirement, you may change your allocation to be closer to 50% of your investments in more conservative mutual funds, 10% in real estate, 5% in cash or money market accounts, and 35% in bonds.
Alternative asset allocation tactics are virtually limitless. Nevertheless, there are several factors that–once addressed and discussed with an experienced financial expert, may assist you in determining the appropriate asset allocation combination for your specific position.
Choosing the right assets according to your current situation, future situation, investment objectives, and risk tolerance are imperative to your success as an investor. These
Personal financial goals and objectives
What are your your investment goals? Do you need your investment portfolio to return income in retirement?
Current age and time horizon for investment
Your time horizon is the expected number of months, years, or decades you will be investing to reach a particular financial goal. If you are an investor with a longer time horizon, you may feel more comfortable taking on a riskier, or more volatile investment because you can wait out and economic slowdown and the inevitable ups and downs of the stock market. By contrast, an investor close to retirement would likely take on less risk because he or she has a shorter time horizon.
Current risk tolerance
Risk tolerance is your ability and comfort level to lose some (or all) of your original investment in exchange for the chance at bigger gains. The higher the risk– the greater the reward, but this requires the stomach to handle big swings in stock price. An aggressive investor is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to choose investments that wont have price swings of %10 or more on a given day.
Your current age should play into your investment allocation. Target date funds are a great way to easily invest your money– no matter the market conditions, as they are automatically invested into a strategic asset allocation. If you are many years away from needing to access your investments– you are known as a long-term investor and choose more risky assets. However, if you will need the funds soon– you should choose low-risk assets such as bond funds, short term funds, or dividend stocks.
Present and future income
The amount of money you earn today and the amount you earn in the future play a part in choosing the best asset allocation for your investment money. For example if you are in a high tax bracket today, you probably want to take advantage of tax-deferred investment accounts such as a Traditional IRA or employee sponsored 401(k). Within these tax-friendly accounts you can allocate your money into a wide-range of diversified index funds.
If you are just starting to invest and are currently in a low tax bracket, a Roth IRA may be the best place to start investing. By paying the taxes now and putting your investment dollars to work in a Roth IRA, you can amass a large amount of money through compound interest– with tax-free gains.
What does this have to do with asset allocation? It's all about WHERE you put those investment dollars. Company sponsored investment accounts (401k/403b) have a limited number of investment options, where Roth's and taxable brokerage accounts have many more options to allocate your investments.
Intention to preserve or liquidate your capital
If you are the type of investor that wants (or needs) access to their initial investment dollars– it's important to choose the right assets for your money.
Diversified index funds, bonds, or bond funds are a great way to allocate your capital into an investment – with a lower risk than many individual stocks, and still have access (liquidity) to your contributions.
Where exactly can you allocate your investments?
There are an endless amount of ways to invest your money – stocks, index funds, corporate and municipal bonds, bond mutual funds, lifecycle funds, exchange-traded funds, money market funds, and U.S. Treasury securities are just a few of the most common.
Many financial professionals recommend allocating your investments into a mix of stocks, bonds, and cash. Let’s take a closer look at the characteristics of the three different types asset.
Stocks are perhaps the most talked about investment asset of all time. Stocks have historically enjoyed the highest returns among the three major asset categories. Stocks are a portfolio’s greatest chance for potential growth. While, there is no guarantee of future results, many people have used stocks to generate great wealth. The volatility of the stock market makes individual stocks a risky investment in the short term. Investors with a stomach for risk and are willing to ride out the volatile returns of stocks over long periods of time – generally have been rewarded with great portfolio gains.
Bonds are generally less volatile than stocks but also offer much more modest returns. Traditionally, as an investor is approaching a financial goal (like retirement) they might increase their bond holdings relative to their stock holdings. By allocating more bonds into a portfolio, it reduces the risk of capital loss, despite the lower potential for growth.
Cash and cash equivalents – such as savings accounts, certificates of deposits, treasury bills, money market accounts, money market funds, and the envelope under your mattress – are traditionally some of the safest investments for your money. So safe in fact that they are hard to even call investments since they offer the lowest return on your capital. The federal government guarantees many investments in cash equivalents or money market accounts since you are essentially just parking the cash into a bank account.
The principal concern for investors investing in cash equivalents is inflation risk– something we've been hearing a lot about lately. This is the risk that inflation will outpace and erode investment returns over time.
What about other Asset Categories?
Like we said, there are a million places to invest your money. Other asset categories – including real estate, crypto-currency, precious metals, art/collectables, and even private equity are places investors may allocate their investments within a portfolio. Investments in these asset categories typically have category-specific risks. You should be sure to understand the risks of any investment before you venture into the unknown!
What is Diversification of an Investment?
Diversification in investing refers to the proportion of your portfolio that is comprised of the same asset class. The greater the difference in the investments you have, the more diverse your portfolio is.
And, diversity in investing – is a good thing.
For example, owning shares of different types of companies or investing in different industries such as energy, technology, home goods, consumer staples, Real Estate and Fixed Income will lead to more diversification.
Holding assets in several segments of a particular asset class might give you even more diversity than holding assets from a single sector within a single asset class.
For instance, holding 50 shares all connected to the technology industry will not offer the same level of diversity as holding all stocks in the S&P 500.
Therefore, the more dispersed you get– the less tied you are to one asset or asset class if it were to suddenly tank. If you held 100% tech stocks in 2022 – your portfolio would see a lot more red than if your portfolio was diversified with all the other sectors .
The top management may find it challenging to adopt diversification owing to the concentrated share position they may have amassed through their company's equity incentive programs. Exchange-traded funds and index proxy methods are two of the most successful diversification options for supersaturated share investments.
Diversification can help you navigate the storm of market volatility, but it will look different for each investor because there is no such thing as a one-size-fits-all strategy.
Asset Allocation vs Diversification vs YOU
Though asset allocation considers the many types of assets in your portfolio as a whole, diversification considers the amount of each of these assets in your strategy. These exist to protect your portfolio from YOU.
Diversification techniques work in conjunction with asset allocation tactics to provide customers with a risk exposure that matches their tolerance for risk while limiting negative prospects because of the failure of one or even more specific assets.
The concentration of these assets may have an impact on your prospective gains, and that, in effect, could have an impact on your entire asset allocation plan.
Some asset classes also have subclasses. Consider bonds, for instance. Bond investments might include US Treasury securities, corporate debt, high-yield bonds, and municipal bonds.
The purpose of this article is to instill confidence in investors in their understanding of such concepts and associated ramifications. You'll be more secure in your financial choices after you grasp the differences between these two phrases (and many others).
So, when it comes between asset allocation and diversification– would having a restricted stock holding cause your asset allocation to be less diverse? Although it is dependent on your specific circumstances– the simple answer is yes.
The more asset classes or assets you invest in will lead to more diversification.