Asset Allocation & Diversification: Balancing The Risks of Investing

"Sound asset management requires both asset allocation and diversification."

Studies have found that, over the long run, how your investments are allocated is more important than individual investments, in determining overall performance for diversified portfolios.

That’s right. It’s not necessarily the specific investments you choose, but how those investments are allocated that may make the difference in reaching your financial goals. Furthermore, the process of selecting an appropriate investment mix encourages you to organize your investments and consider your financial needs and risk tolerance, as well as external factors such as inflation, taxes, interest rates and the current economy.

Asset allocation is a common strategy that you can use to construct an investment portfolio. Asset allocation isn't about picking individual securities. Instead, you focus on broad categories of investments, mixing them together in the right proportion to match your financial goals, the amount of time you have to invest and your tolerance for risk.

Asset Allocation Basics

The idea behind asset allocation is that because not all investments are alike, you can balance risk and return in your portfolio by spreading your investment dollars among different types of assets, such as stocks, bonds and cash alternatives. It doesn't guarantee a profit or ensure against a loss, of course, but it can help you manage the level and type of risk you face.

Different types of assets carry different levels of risk and potential for return, and typically don't respond to market forces in the same way at the same time. For instance, when the return of one asset type is declining, the return of another may be growing (though there are no guarantees). If you diversify by owning a variety of assets, a downturn in a single holding won't necessarily spell disaster for your entire portfolio.

Using asset allocation, you identify the asset classes that are appropriate for you and decide the percentage of your investment dollars that should be allocated to each class (e.g., 70 percent to stocks, 20 percent to bonds, 10 percent to cash alternatives).

The Three Major Classes of Assets

Here's a look at the three major classes of assets you'll generally be considering when you use asset allocation.

Stocks: Although past performance is no guarantee of future results, stocks have historically provided a higher average annual rate of return than other investments, including bonds and cash alternatives. However, stocks are generally more volatile than bonds or cash alternatives. Investing in stocks may be appropriate if your investment goals are long-term.
Bonds: Historically less volatile than stocks, bonds do not provide as much opportunity for growth as do stocks. They are sensitive to interest rate changes: when interest rates rise, bond values tend to fall, and when interest rates fall, bond values tend to rise. Because bonds offer fixed interest payments at regular intervals, they may be appropriate if you want regular income from your investments.
Cash Alternatives: Cash alternatives (or short-term instruments) offer a lower potential for growth than other types of assets but are the least volatile. They are subject to inflation risk, the chance that returns won't outpace rising prices. They provide easier access to funds than longer-term investments and may be appropriate for investment goals that are short-term.

Not only can you diversify across asset classes by purchasing stocks, bonds and cash alternatives, you can also diversify within a single asset class. For example, when investing in stocks, you can choose to invest in large companies that tend to be less risky than small companies. However, you could choose to divide your investment dollars according to investment style, investing for growth or for value. Though the investment possibilities are limitless, your objective is always the same: to diversify by choosing complementary investments that balance risk and reward within your portfolio.

Asset Allocation Versus Diversification

On the surface, asset allocation may sound very similar to diversification. Indeed, the principles are closely related; both are designed to reduce risk in your portfolio. At its most basic, diversification means spreading money among several different investments. By diversifying into a variety of alternatives, you can mitigate the chances of suffering a catastrophic loss should one of the investments perform poorly.

Asset allocation takes this principle one step further by diversifying your portfolio not just among different investments, but among different investment classes: stocks, fixed income alternatives such as bonds, cash equivalents and real estate and other tangible assets. Every investment involves some level of risk. Even CDs, traditionally considered safe, carry the risk that the rate of return received may not be enough to outpace inflation and taxes. Therefore, speak to your advisor and carefully plan the strategy that is best suited to your risk tolerance as well as your future goals and objectives.

Asset allocation does not eliminate risk, but it can reduce your exposure to extreme highs and lows in performance. Effective asset allocation can also help preserve capital, increase liquidity and decrease portfolio volatility.

Only after exploring your individual needs and goals for the future can we recommend a tailored asset allocation strategy.