Investment Principles: Diversification and Asset Allocation
When it comes to the complicated task of growing your wealth, how do you develop an investment strategy that works for you? For many people, the answer lies in diversification and asset allocation.
Diversification and asset allocation are the two pillars of a solid investment strategy. Understanding these two different (yet closely related) concepts will help you be better able to make investment decisions that will position you to achieve lasting financial success. Below is a brief primer on these two fundamental principles of investing.
Simply put, diversification involves spreading the total dollars that you have available to invest across a variety of different categories. By diversifying your investments in the financial markets today, you can reduce the overall risk to your portfolio, since you haven’t put all of your eggs in one basket, so to speak.
For example, let’s say you are nearly 100% confident that a particular stock is going to spike in value in the near future. You may be tempted to put all of your money into that one stock, so that you can take full advantage of the huge anticipated gains. But that strategy can backfire if instead of rising, the stock’s value plummets. If you put all your money into that one stock and it later tanked, it could be very difficult to recover from the loss in the market today.
Diversification—holding investments in a variety of categories—helps mitigate the effect of any one negative event on your portfolio. How does diversification work? Different types of investments tend to rise and fall at different times. That means that as one investment is falling, another may be rising. By having investments in a range of industries and in non-U.S.-based companies, as well as different kinds of bonds, you can reduce your overall stock portfolio risk.
Diversifying your investments is an important step in building a strong portfolio. But diversification alone is not enough to adequately manage risk. That’s because diversification by itself doesn’t do enough to protect you from losses. To further reduce risk, you need to look at asset allocation.
Asset allocation is similar to diversification, but it goes a bit further. In some ways, it’s like a more scientific form of diversification. Rather than just picking a bunch of different stocks that you suspect carry different types of risk, asset allocation involves looking at historical risks and returns of investments in different categories. Then, you assign a set percentage of your portfolio to each category. The theory is that while one category is declining, another may be rising, while a third may be holding steady, so that, when everything is working together, your portfolio will stay in balance.
Asset allocation may sound relatively simple, but there’s a lot of work that goes into determining the best asset allocation for a specific individual’s situation. The proper asset allocation depends on a wide variety of factors, including a person’s age, individual risk tolerance, total assets and long-term investment objectives. For example, if you are saving for retirement, your asset allocation will likely become more conservative the closer you get to your retirement date. Often, it’s helpful to work with a financial planner to determine the specific asset allocation that will work best for you.
How Diversification and Asset Allocation Work Together
Asset allocation is a tool that you can use to help you achieve diversification in your portfolio. In tandem, both strategies can help you achieve your long-term financial goals. If you have questions about how you can use the principles of asset allocation and diversification in your own investment portfolio, consider consulting with a financial advisor. He or she can help you develop an investment strategy that positions you to achieve your goals.
By Chris Cooper, CFP®