Asset Allocation and Diversification — In Plain Words

This page is educational only. It is not financial advice.

What is asset allocation?

Asset allocation involves dividing your investments among different assets, such as stocks, bonds, and cash.

The asset allocation decision is a personal one.

The allocation that works best for a person changes at different times in life, depending on the investing timeframe or time horizon and on risk tolerance.

Investing timeframe or time horizon

Your investing timeframe, also called your time horizon, is the number of months, years, or decades you plan to invest to achieve your financial goal.

Investors with a longer time horizon may feel comfortable taking on riskier or more volatile investments.

Those with a shorter time horizon may prefer to take on less risky or less volatile investments.

Risk tolerance

Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for potentially greater returns.

In general, as investment risks rise, investors seek higher returns to compensate themselves for taking such risks.

An investor with a high risk tolerance is willing to risk losing money to get potentially higher returns.

An investor with a low risk tolerance favors investments that seek to maintain their original investment.

Free online questionnaires

Some investment websites offer free online questionnaires to help assess risk tolerance and estimate asset allocations.

Investor.gov gives this warning: the results may be biased towards financial products or services sold by companies or individuals sponsoring the websites.

Rebalancing

Over time, some investments will grow faster than others.

This may push holdings out of alignment with investment goals and change the risk level of a portfolio.

Bringing a portfolio back to its original asset allocation is called rebalancing.

Investor.gov gives this example: a portfolio might start with 60% invested in stocks, but see that rise to 80% due to market gains.

To reestablish the original asset allocation mix, some stocks may be sold, or additional money may be invested in other asset categories.

Investor.gov reports what some financial experts advise: some advise rebalancing at regular intervals, such as every six or 12 months.

Others recommend rebalancing when holdings of an asset class increase or decrease more than a pre-set percentage.

In either case, rebalancing tends to work best when done relatively infrequently.

What is diversification?

Diversification is the practice of spreading money among different investments to reduce risk.

Investor.gov sums it up this way: “Don’t put all your eggs in one basket.”

When determining asset allocation, diversification is part of the picture.

Diversifying across asset classes

One way to diversify is to allocate investments among different kinds of assets.

Factors or market conditions that may cause one asset class to perform poorly may improve returns for another asset class.

People invest in various asset classes in the hope that if one is losing money, the others make up for those losses.

Diversifying within each asset class

Investor.gov also describes spreading investments within each asset class.

That could mean holding a number of different stocks or bonds, and investing in different industry sectors, such as consumer goods, health care, and technology.

That way, if one investment or sector is doing poorly, other holdings that are doing well may offset it.

Funds and ETFs

Some investors find it easier to diversify by owning mutual funds or exchange-traded funds (ETFs).

Mutual funds and ETFs are investment companies that pool money from many investors and invest the money in stocks, bonds, and other assets.

These funds make it easy for investors to own a small portion of many investments.

But a mutual fund or ETF won’t necessarily provide diversification, especially if it is narrowly focused, such as on one industry sector.

If a person invests in narrowly focused funds, several funds may be held in the mix.

Investor.gov also notes this point: even when a person holds several mutual funds or ETFs, the top holdings of the funds can be checked to make sure they are different and provide the diversification being sought.

How allocation and diversification differ

Asset allocation is the mix among different asset classes, such as stocks, bonds, and cash.

Diversification is spreading money among different investments to reduce risk.

That spreading happens across asset classes and also within each asset class.

In short: allocation names the mix among asset classes. Diversification names the spreading within and across them.

This page is educational only. It is not financial advice.