Asset allocation and diversification are cornerstone investing strategies designed to optimize the balance between risk and reward within an investor’s portfolio. Asset allocation involves strategically distributing investments across a variety of asset classes, while diversification entails spreading investments across different sectors or geographical regions to mitigate the risks associated with any single investment. If you need help managing your portfolio or selecting an investment strategy, consider working with a financial advisor.
What Is Asset Allocation?
Asset allocation is a fundamental strategy in investment management that involves spreading investments across asset classes, including stocks, bonds and cash equivalents. Asset allocation takes an investor’s risk tolerance, time horizon and other individual factors into account and looks to optimize a balance between risk and reward. By diversifying investments, asset allocation helps in reducing the impact of volatility in any single asset class, thereby stabilizing the overall performance of the portfolio over time.
Why does asset allocation matter? The 1991 study from Brinson, Singer, and Beebower found that asset allocation accounts for more than 90% of the variability in a portfolio’s returns over time.
Strategic vs. Tactical Asset Allocation
Strategic asset allocation is a long-term investment approach designed to meet enduring financial goals. It involves setting a predetermined asset mix, such as 60% in equities, 30% in bonds and 10% in cash, and periodically rebalancing the portfolio to align with these targets.
The primary advantage of strategic asset allocation is its focus on maintaining a balanced and diversified portfolio that supports the investor’s long-term financial aspirations, aiming to provide a stable growth trajectory over an extended period.
On the other hand, tactical asset allocation is a more dynamic and flexible strategy that allows investors to adjust their asset mix in response to short-term market conditions and opportunities.
For example, an investor might increase their equity exposure during a market downturn to capitalize on lower stock prices and potential future gains. While tactical asset allocation offers the possibility of higher returns by exploiting market conditions, it also requires more active management and entails greater risk. This approach is particularly suitable for experienced investors who are capable of making informed decisions based on short-term market trends and who are comfortable with the associated risks.
What Is Diversification?
Diversification primarily aims at reducing risk by spreading investments within a particular asset class. This can mean investing in a variety of industries, geographic regions or financial instruments within a single asset class. The principle behind diversification is simple: By not putting all your financial resources into one type of investment or market, you minimize the risk of significant loss if that particular market underperforms.
Within a stock portfolio, for example, diversification could mean investing in various sectors such as technology, healthcare and consumer goods, rather than concentrating on one industry.
This approach aims to minimize the risk associated with a single investment’s poor performance. If one sector underperforms, the impact on the portfolio is softened by the better performance of investments in other sectors.
In essence, asset allocation and diversification are complementary strategies. Asset allocation sets the foundation by deciding where to invest, and diversification enhances this foundation by spreading risk within those choices, creating a more resilient investment portfolio.
Benefits of Asset Allocation vs. Diversification
Asset allocation and diversification aim to balance risk and enhance potential returns across a portfolio. For example, during periods of market volatility, stocks may experience a decline, but bonds and real estate might maintain or increase in value, thereby stabilizing the overall portfolio. This diversified mix helps manage the risk-return profile of a portfolio by leveraging the strengths of each asset class.
Diversification also plays a role in reducing the volatility of an investment portfolio by allocating investments across different sectors or geographical locations. This strategy is particularly effective in protecting against sector-specific risks, such as a downturn in the technology sector that might not impact the utilities sector.
Additionally, geographical diversification can mitigate risks associated with investing in a single country or region. It allows investors to capitalize on growth opportunities in emerging markets while balancing exposure to more mature markets.
Potential Drawbacks of Asset Allocation and Diversification
One significant drawback of asset allocation and diversification is the risk of over-diversification. This occurs when investments are spread too thinly across too many assets or asset classes, potentially diluting the overall returns of the portfolio.
For example, consider an investor who, in an attempt to “play it safe,” excessively diversifies their portfolio. This investor might find that their investments merely mirror broad market returns but incur higher transaction fees and management costs, thus eroding net gains. Over-diversification can lead to a scenario where the portfolio becomes less effective, especially in low-interest-rate environments where safer asset classes yield minimal returns.
Effectively implementing asset allocation and diversification strategies also requires accurate assessment of correlations between different asset classes. Correlations measure how similarly different investments perform relative to each other – a misunderstanding of these relationships can expose the portfolio to unexpected risks.
During the 2008 financial crisis, for example, many assets that were traditionally viewed as non-correlated exhibited similar downturns, resulting in amplified losses for diversified portfolios.
Asset Allocation and Diversification in Action
To better understand these strategies, let’s take an example of an investor with $200,000. They allocate 50% of their portfolio to stocks, 30% to bonds and 20% to real estate. And within their stock investments, they diversify by allocating 20% to technology, 15% to healthcare, 10% to financial services and 5% to consumer goods. This specific distribution is chosen to balance their exposure to different market dynamics and growth potentials in each sector.
For bond investments, the investor opts for a mix of government and corporate bonds, dedicating 20% to high-yield bonds and 10% to municipal bonds, aiming to blend stability with higher returns. And in the real estate sector, they invest in both residential properties and a real estate investment trust (REIT) focusing on commercial properties.
This strategic allocation and diversification enables the investor to spread their risk across different asset classes and within those classes, across various sectors and regions. Such a balanced approach can not only enhance their chances of achieving stable returns but also position their portfolio to potentially capitalize on different economic conditions and market opportunities over time.
Importance of Rebalancing
Rebalancing a portfolio allows an investor to maintain the intended asset allocation and diversification within that portfolio over time. This process involves adjusting proportions of various asset classes to align with predetermined investment goals and risk tolerance levels.
For example, significant market movements can skew the original asset allocation, making some assets weigh more heavily than initially planned. If the equity portion of a portfolio outperforms the bond portion, it could lead to an increased risk level, deviating from the investor’s comfort zone. Rebalancing in such scenarios helps in restoring the balance, ensuring that the portfolio continues to meet the strategic investment objectives initially set out.
Bottom Line
Asset allocation and diversification are investment management strategies designed to balance risk and optimize returns. By strategically distributing investments across different asset classes and diversifying within those classes, investors can mitigate the impact of volatility and enhance the potential for stable, long-term growth. While these strategies are essential for constructing robust portfolios, they require careful implementation and periodic rebalancing to align with changing market conditions and personal financial goals.
Investing Tips
- If you need help picking an asset allocation that aligns with your risk tolerance, try SmartAsset’s asset allocation calculator. The free tool will give you a suggested split between stocks, bonds and cash, and even provide a potential breakdown of different types of potential investments within each.
- A financial advisor can also help you build a portfolio designed to meet your needs. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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