Diversification is critical to a strong portfolio over the long term. Every now and again, someone might get lucky and pull an “everything into Apple in 2005,” but single-security or single-asset portfolios are a huge gamble. For every investor who sees their $1.50 stock leap to $170, there are 10 or 20 who see their big bet collapse. The key to understanding diversification is in these two terms: asset allocation and security selection.
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What Is an Asset Allocation?
Asset allocation is how you select and balance the asset classes in your portfolio. It refers to how your portfolio is divided among different types of investments.
An asset class is a general type of security or investment. For example, stocks are an asset class. No matter what company, so long as you’re trading shares of ownership in a business you are generally trading stocks. The most common asset classes for an individual investor include stocks, otherwise known as equities, bonds, also known as fixed-income securities, mutual funds, exchange-traded funds (ETFs) and real estate. Increasingly, individual investors have also begun trading options contracts in recent years.
Asset allocation, then, refers to how you balance those different asset classes in your portfolio. For example, having 60% of your money invested in equities and 40% in bonds would be a description of your portfolio’s asset allocation.
How to Make Asset Allocation Decisions
Different asset classes respond to the market in their own ways. This is called asset correlation. By allocating your portfolio among different types of assets, you can give it more stability regardless of how the market moves. In other words, a loss in one asset class can be offset by a gain in another one.
While there a number of factors that determine how an investor will diversify through asset allocation, three are particularly important. They are an investor’s risk profile, financial goals and overall timeline.
Risk Profile
Your risk profile is how much risk of loss you’re willing to accept in exchange for the possibility of larger gains. Higher risk assets, such as equities, have the potential to do much better than a safer product, like bonds. On the other hand, you’re also more likely to experience losses, at least in the short term, with a riskier asset.
When you build and manage a portfolio, you balance, or allocate, assets in the portfolio according to your risk tolerance at any given moment. If you can accept greater risks, such as when you are younger, you will allocate more of your portfolio toward higher-risk assets. When you need more security, such as when you are closer to or in retirement, you will shift toward safer assets.
Financial Goals
Your goals describe what you’re investing for. While many investors will build portfolios simply because it’s wiser than holding everything in cash, most will also have portfolios built for specific goals.
For example, your retirement portfolio is focused on the goal of allowing you to retire. Your timeline for that portfolio would be the number of years you have left until you retire. Other investors might have portfolios for college funds, buying a house, taking a trip or other things.
Overall Timeline
Your timeline will generally determine the risk profile you want for your portfolio. While some situations will differ, the conventional wisdom is this: The farther away your goal, the more risk you should accept in your portfolio. You can grow your money quickly if those risks pay off, but you still have time to earn more money and make up for any losses.
The closer your goal, the less risk you should accept in your portfolio. While you likely won’t grow your money as quickly, you’re less likely to lose money you can’t afford to.
What Is Security Selection?
Asset allocation is necessary to achieve diversification, but it’s not sufficient alone. In short, it’s a blunt instrument. Fully diversifying requires a more precise instrument, namely, security selection. That refers to the individual holdings you purchase within your investment portfolio.
For example, you might decide to invest 10% of your portfolio in energy investments. This would be an asset allocation decision. Then you would select which specific energy producers to invest in, such as ExxonMobil, Royal Dutch Shell, BP and others.
It’s important not to gloss over security selection, as these choices matter enormously. If you want to invest in real estate, it makes a huge difference whether you put your money into an apartment building in downtown Boston or a farm in the Upper Peninsula of Michigan. Buying 1,000 shares of Tesla is vastly different from buying 1,000 shares of GameStop, even though both belong to the asset class of tech stocks.
Security selection is also what funds are for. Mutual funds and ETFs are portfolios made up of several different securities in one place. When you invest in one of these assets, your returns come from the average returns of all the underlying securities within this portfolio.
This approach has many advantages, including the fact that they help investors avoid the difficult process of finding worthwhile investments. So if you want to invest in real estate, you don’t necessarily need to understand the real estate market. You can simply look for a real estate ETF with strong performance. They would’ve then used their expertise to find the individual properties.
Fund-based investments are often an extremely good choice for most investors. However, don’t forget: Even here, you still need to select which funds to invest in.
Bottom Line
Diversifying your holdings is a cardinal principle of investing. Investors observe this principle in two ways. One is asset allocation, which refers to how you balance different asset classes in your portfolio; another is security selection, which refers to which individual holdings you buy.
Investing Tips
- Consider working with a financial advisor as you make critical decisions about both asset allocation and security selection. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Use SmartAsset’s asset allocation calculator to settle on an asset allocation that works for you.
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