Asset Allocation and Diversification
What is asset allocation?
What is diversification?
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 you changes at different times in your life, depending on your investing timeframe or time horizon and your 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.
Some investment websites offer free online questionnaires to help you assess your risk tolerance and/or estimate asset allocations. Keep in mind 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 your holdings out of alignment with your investment goals and change the risk level of your portfolio. To bring your portfolio back to its original asset allocation, you may need to rebalance your portfolio.
For example, you might start with 60% of your portfolio invested in stocks, but see that rise to 80% due to market gains. To reestablish your original asset allocation mix, you may need to sell some of your stocks and/or invest additional money in other asset categories.
Shifting money away from an asset class when it is doing well and/or in favor of an asset category that is doing poorly may not be easy. But it can be a wise move. By cutting back on current “winners” and/or adding more current “losers,” rebalancing forces you to buy low and sell high.
Some financial experts advise rebalancing at regular intervals, such as every six or 12 months. Others recommend rebalancing when your 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.
In a target date fund, the fund’s investment adviser takes care of rebalancing the fund’s asset allocation over time in a way that is typically intended to become more conservative as you approach the target date.
What is diversification?
When determining your asset allocation, consider diversification— the practice of spreading money among different investments to reduce risk. Diversification is a strategy that can be neatly summed up as: “Don’t put all your eggs in one basket.”
One way to diversify is to allocate your 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.
You’ll also be better diversified if you spread your 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, you may offset it with other holdings that are doing well.
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 you invest in narrowly focused funds, you may need to invest in several to be diversified. In addition, even if you hold several mutual funds or ETFs and think you are diversified, you should check the top holdings of the funds to make sure they are different and provide the diversification you are seeking.
