Back to Basics: Diversification and Asset Allocation
August 14, 2018
When investing, particularly for long-term goals, there are two concepts you will likely hear about over and over again — diversification and asset allocation.
Diversification helps limit exposure to loss in any one investment or one type of investment, while asset allocation provides a blueprint to help guide your investment decisions. Understanding how the two work can help you put together a portfolio that targets your specific needs.
Diversification: Spreading out risk
Diversification refers to the process of investing in a number of different securities to help manage risk. The theory is that if some investments in your portfolio decline in value, others may rise or hold steady.
For example, say you wanted to invest in stocks. Rather than investing in just domestic stocks, you could diversify your portfolio by investing in foreign stocks as well. Or you could choose to include the stocks of different size companies (small-cap, mid-cap, and/or large-cap stocks).
If your primary objective is to invest in bonds for income, you could choose both government and corporate bonds to potentially take advantage of their different risk/return profiles. You might also choose bonds of different maturities, because long-term bonds tend to react more dramatically to changes in interest rates than short-term bonds. As interest rates rise, bond prices typically fall.
Asset allocation: Investing strategically
Asset allocation is a strategic approach to diversifying your portfolio among different asset classes that seeks to pursue the highest potential return within a certain level of risk. After carefully considering your investment goals, time horizon, and risk tolerance, you would then invest different percentages of your portfolio in targeted asset classes to pursue your goals. A careful analysis of these three personal factors can help you make strategic choices that are suitable for your needs.
Generally speaking, a large accumulation goal, a high tolerance for risk, and a long time horizon would typically translate into a more aggressive strategy and therefore a higher allocation to stock/growth investments.
The opposite is also true: A small accumulation goal (or one geared more toward generating income), a low tolerance for risk, and a shorter time horizon might require a more conservative approach.
Rebalance to stay on target
Over time, an asset allocation can shift simply due to changing market performance. For example, in years when the stock market performs particularly well, a portfolio may become overweighted in stocks. Or in years when bonds outperform, they may end up comprising a larger-than-desired percentage of the portfolio. In these situations, a little rebalancing may be in order.
There are two ways to rebalance. The first is by simply selling securities in the overweighted asset class and directing the proceeds into the underweighted ones. The second method is by directing new investments into the underweighted asset class until the desired allocation is achieved.
Keep in mind that selling securities can result in a taxable event, unless they are held in a tax-advantaged account, such as an employer-sponsored retirement plan or an IRA.