Many people often use the terms “asset allocation” and “diversification” interchangeably. These two terms, while often used in the same way, 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.
What is Asset Allocation?
Think of asset allocation as the starting point for building your investment portfolio. Before you and your financial advisor select specific mutual funds, you decide what 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 them may help reduce your portfolio’s volatility over time.
Your specific mix of assets depends on your goals, risk tolerance, and timeframe. Historically, stocks generate greater long-term returns, along with more short-term volatility, than bonds or money market instruments1. If you 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 may feel comfortable allocating more of your portfolio to stocks because you may be able to ride out their intermittent ups and downs. The original allocation you choose won’t always be appropriate. You need to rebalance your portfolio as your circumstances or market conditions change.
What is Diversification?
Once you and your financial advisor determine your target asset allocation, it’s time to consider diversification2. 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 under performers.
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 can 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 you’re taking full advantage of both, consult your financial advisor.And remember, you and your advisor should review strategies you implement today and revise them on a regular basis.