While asset allocation and diversification are often referred to as the same thing, they aren’t. These two strategies both help investors to avoid huge losses within their portfolios, and they work in a similar fashion, but there is one big difference.
Diversification focuses on investing in a number of different ways using the same asset class, while asset allocation focuses on investing across a wide range of asset classes to lessen the risk.
When you diversify your portfolio, you focus on investing in just one asset class, like stocks, and you go deep within the class with your investments.
That could mean investing in a range of stocks that have large-cap stocks, mid-cap stocks, small-cap stocks, and international stocks and it could mean varying your investments across a range of different types of stocks, whether those are retail, tech, energy, or something else entirely but the key here is that they’re all the same asset class: stocks.
Asset allocation, on the other hand, means you invest your money across all categories or asset classes. Some money is put in stocks and some of your investment funds are put in bonds and cash or another type of asset class. There are several types of asset classes, but the more common options include:
There are also alternative asset classes, which include:
- Real estate, or REITs
- Commodities
- International stocks
- Emerging markets
When using an asset allocation strategy, the key is to choose the right balance of high- and low-risk asset classes to invest in and allocate the right percentage of your funds to lessen the risk and increase the reward.
For example, as a 30-year-old investor, the rule of thumb says to invest 70% in riskier investments and 30% in safer investments to ensure you’re maximizing risk vs. reward.
Well, you could allocate 70% of your investment to a mix of riskier investments, including stocks, REITs, international stocks, and emerging markets, spreading that 70% across all these types of asset classes. The other 30% should go to less risky investments, like bonds or mutual funds, to lessen the risk of losses.
As with diversification, the reason this is done is that certain asset classes will perform differently depending on how they respond to market forces, so investors spread their investments across asset allocations to help protect their money from downturns.
Learn how to optimize your investments based on your age with our Asset Allocation By Age article.
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