A Guide to Asset Allocation and Diversification
- Asset allocation is spreading your investments across different asset classes – equities (stocks), bonds, cash, so economic factors like inflation or interest rate hikes don’t have a disproportionate impact on all your investments.
- Diversification is spreading your money across various investment types including stocks, mutual funds, bonds and more, so risk can be decreased in case one of the investments decreases in value.
- Diversification and asset allocation go hand-in-hand to potentially help maximize returns while minimizing risks over time.
“Don’t put all your eggs into one basket” can apply to many aspects of life from seeking admission to college, looking for a job or trying different ticket sources for tickets to a “must-attend” event. However, the phrase becomes especially important when you’re investing for financial goals like buying a home, paying for college tuition or building a retirement nest egg.
Having the money you need to live the life you want now and well into the future requires maximizing returns, while taking on the appropriate amount of risk. It’s challenging to get the returns you want for big-ticket goals such as a home, college or retirement without taking on some risk. Historically, the return on safer investments such as savings, money market accounts or even bonds have not surpassed inflation by much, while investments like stocks and mutual funds tend to outpace inflation. Risk is different for everyone, and you have to find the right balance of risk and reward for you.
Asset allocation and diversification are two approaches that can help you do both simultaneously.
Asset Allocation
Asset allocation is the process of figuring out how much to invest in different assets classes – equities, bonds, cash equivalents, real estate, commodities – based on three factors:
- Time horizon – How much time do you have before you need the money for a goal such as paying for college or retirement? The more time you have, the more risk you can take in your investment portfolio. Conventional wisdom is that younger investors always have a longer time horizon and more mature investors have a shorter one, but that only accounts for age. However, the time horizon can also be contingent on where you are in your financial journey with respect to how much time you have to achieve each goal.
- Risk tolerance – While your age and the value of your investment portfolio are part of the make-up of your risk tolerance, your emotions and overall comfort with taking on risk are also factors you need to consider.
- Investment objectives – Ultimately, your objectives determine how much in returns you will need to grow enough money for each goal and how much risk you may need to take to get those returns. That’s why it’s important to identify and re-evaluate your objectives throughout your financial journey and develop a financial plan that includes your current financial needs as well as future goals.
Diversification
Diversification goes hand-in-hand with asset allocation. Once you’ve identified your appropriate asset allocation mix, you can diversity by simultaneously investing in different investment vehicles like stocks (equities), mutual funds, bonds and cash equivalents (money market accounts) rather than putting all your money into one investment. With this approach, if one of the investments decreases in value, your entire portfolio might not decrease with it.
Further diversification can be achieved by targeting different industries (e.g. technology, healthcare, energy, entertainment, etc.) or geographical regions (e.g. US, South America, Europe, Asia, etc.). Depending on the amount of research you want to do on your own, you can invest in individual stocks or use a professionally-managed pooled investment vehicle like Exchange Traded Funds (ETFs) or mutual funds.
Diversification and asset allocation can seem like a bit of a puzzle, but it’s important to include both approaches in your financial plan. If you need help or want a second opinion on our investment strategy, seek professional guidance from an experienced Wealth Advisor. Wealth Management by CommunityAmerica is here to help regardless of where you are on your financial journey. Schedule a complimentary consultation with a Wealth Management by CommunityAmerica Wealth Advisor today.
