Lisa Whitley — For this short series of articles, we’ll explore the differences between common financial vehicles. Maybe you know already, perhaps you don’t; either way a rising tide lifts all boats!
What is the difference between asset allocation and diversification?
As a new investor, one of the very first concepts that you will grapple with is the difference between asset allocation and diversification. Once you understand this, you will be in a place to approach your investing decision with more confidence.
There are different “classes” of investments: stocks (equity), bonds, real estate, even precious metals. Each of these classes react differently to economic conditions. For example, when stock prices go up, usually bond prices go down. So when we build our investment portfolio, we can smooth out big fluctuations in returns by holding a mix of asset classes, most typically some stocks and some bonds. That is asset allocation: how much of each investment class you hold in your portfolio.
Diversification sounds the same, but is a bit different. Let us say that in your portfolio, which may be your retirement account, you allocate 50% of your money to a bond fund and 50% to a stock fund. And that stock fund is designed to match the performance of the S&P 500 index. You will hold a wide variety of company stocks…but these companies will all be rather similar: very large, American companies. What about small or medium-sized companies? What about foreign companies? In this case, while you have paid attention to asset allocation, within your stock holdings you are not very well diversified. Diversification means owning a variety of investment types within a particular asset class. Just as with asset allocation, the goal of being well diversified is to hold a variety of investments that will act differently in response to the economy.
In short, you must decide how to allocate your investment portfolio between asset classes, and then choose how to diversify within these classes. The right mix for you will be based on your capacity to take risk (based on your age if you are investing for retirement) and your tolerance to withstand changes in your portfolio’s value (based on your emotions).