Frequently I hear these terms used interchangeably, but they are two distinct concepts seeking to solve the same problem. Investing efficiently and effectively is not about randomly picking stocks and bonds because of the possibility of earning a high return, but creating an investment strategy that places you in a position to potentially earn the highest return according to your risk tolerance. Two terms you must understand when creating an investment strategy are diversification and asset allocation. However, as we know, no strategy assures success or protects against loss.
A common saying within the investing world is to not put all of your eggs in one basket. This saying accurately describes diversification, which includes help reducing your risk by investing across a variety of asset classes. The most common asset classes utilized by investors are stocks, bonds and cash equivalents. Securities have specific characteristics within each asset class. For example, stocks available to investors include blue chips, small cap stocks and foreign stocks. Bonds include corporate bonds, treasury bond and municipal bonds.
Diversification is simply a means to help reduce risk, and does not guarantee a return. Investors may experience a reduction in risk because asset classes rarely react to economic conditions in the same manner and at the same time. For example, while stocks in your portfolio may be declining in value, the government bonds you hold may be increasing in value. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Asset allocation includes determining the percentage of your portfolio to invest in particular asset classes based on your risk tolerance, investment horizon and personal financial goals. For example, young investors can typically take on more risk than investors who are nearing retirement. Stocks have historically offered the highest return out of the common asset classes, but are typically riskier than bonds and cash equivalents. A young investor may choose to allocate 80 percent of their investment portfolio in stocks and 20 percent in corporate bonds. A young investor enjoys a longer investment horizon, and therefore has more time to recoup any losses incurred from investing heavily in stocks.
Asset allocation does not ensure a profit or protection against a loss. Asset allocation is more than about an investor’s age, but also about an investor’s tolerance for risk. Investors who are risk adverse tend to choose conservative assets for their investment portfolios, such as municipal bonds, certificates of deposits and treasury notes. Risk adverse investors desire to stay away from risk, and sometimes choose investments with possible lower returns over risky investments with potentially higher returns. A risk adverse investor may have 75 percent of their investment portfolio in bonds and 25 percent in large-cap stocks.
Proper diversification and asset allocation should eliminate investors’ desires to try and time the markets. The potential reduction of risk can work towards limiting an investor’s losses, even in a down market.