Asset Allocation and Diversification: You Can't Have One Without the Other
While the terms "asset allocation" and "diversification" are sometimes used interchangeably, they are distinctly different strategies. Understanding each and how the pair can work together may be the key to reducing risk and pursuing your long-term goals, even in today's challenging market environment.
First Things First
Think of asset allocation as the starting point for building your portfolio. Before you and a financial professional select specific mutual funds, you decide the percentage of your portfolio to allocate to each of the major asset classes -- stocks, bonds, and money market instruments. Because these asset classes have different risk and return characteristics, combining two or three of them may help reduce your portfolio's volatility over time.
Your specific mix of assets will depend on your goals, risk tolerance (financial and emotional), and time horizon. Stocks historically have generated greater long-term returns, along with more short-term volatility, than bonds or money market instruments.1 If you will need to access your funds within five years, you may want to allocate less of your money to stocks and more to bonds and money market instruments. Conversely, if you have a longer time horizon, you might wish to allocate more of your portfolio to stocks if you are comfortable riding out their intermittent ups and downs.
Of course, the original allocation you choose won't always be appropriate. You'll need to rebalance it periodically as your circumstances or market conditions change.
Once you and a financial professional determine your target asset allocation, it's time to consider diversification. True diversification involves owning a range of securities within each asset class, knowing that different investments may be unlikely to respond to market news or economic developments in the same way. By diversifying, you create the potential for the top-performing investments to help compensate for underperformers.
There are literally dozens of ways to diversify. For example, within a stock fund portfolio, you might combine growth and value funds, or small-, mid- and large-cap funds. Within a bond fund portfolio, you might diversify by holding corporate and government bond funds, or investment-grade and high-yield bond funds.
It's not surprising that asset allocation and diversification are sometimes confused given that the two strategies form such a natural tandem. To be sure that you're taking full advantage of both, consult a financial professional. And remember, you and your advisor should review strategies that you implement today and then revise on a regular basis as your risk and return objectives evolve.
1Past performance does not guarantee future results.