You might have across the investment terms diversification and asset allocation quite often. These are essential concepts used while constructing a financial plan. However, often investors end up using these investment terms interchangeably. Though both these investment concepts aid in managing portfolio risk, are these two terms related? If yes, how exactly? Let’s explore that in this article.
What is asset allocation?
It is an investment strategy that allows investors to balance risk vs rewards by determining the right percentage of each asset class in a financial portfolio. This determination is basis the investment horizon, financial goals under consideration, and the income flows of the investor.
Traditionally, there are three main asset classes in the investing world – equities, debt, and cash and cash equivalents. One can also add precious metals (such as silver, platinum, gold, etc.) or real estate, and alternatives such as other collectables, coins, and art to this asset class mix.
Note that, the portfolio risk adopted is not done on some random whims, but a consequence of an investor’s wealth status.
So if you are an individual with a low risk appetite, or if you are nearing your retirement, your asset allocation strategy would be different than someone who is in their 20s or 30s or someone who has a high risk profile.
Why must an investor invest in different asset classes?
The basic principle behind investing in different asset classes is that when you invest in an array of asset classes that aren’t highly correlated, an investor can successfully reduce the volatility of an investment portfolio. What’s interesting to note here is that it is compulsory for the asset classes to be negatively corelated.
Note that, histrocially, bonds and equities do not move in same direction and the correlation between both these asset classes are low.
Is your portfolio risk fully accounted for with just mere asset allocation strategy? What if an investor invests all their particular asset class such as debt or equity into a single fund or stock? Imagine Raj has a single stock in their portfolio while Ramesh has 10 stocks in his investment portfolio. So in case of Raj, if the company that he has invested in suffers business loss due to any reason, his investment portfolio could take a huge beating. On the other hand, in Ramesh’s case, if any one of the companies that he has invested in suffers business loss, it would not impact his investment portfolio to a huge extent as he is heavily diversified across various stocks. One stock going bad would only impact 1/10th of this investment portfolio.
However, note that though diversifying your portfolio can be quite beneficial to your portfolio, over diversification might turn the tables around and might not be as effective. Experts believe that if an investor diversifies their portfolio beyond 20 or 30 stocks, it would be counter-effective and not make much sense. You can choose to diversify your investments across asset classes (debt, equity, cash and cash equivalents), location (international funds, national funds, regional funds, etc.) and also sector funds. Next time you choose to invest in mutual funds, keep these points in mind. Happy investing!