When it comes to investment strategies, two key concepts often come up in client reviews: asset allocation and diversification. In those meetings, clients often ask, “How is asset allocation different from diversification?”
While the two are related and are often used congruently to manage risk and optimize returns, they are distinct concepts with unique roles in a comprehensive investment plan.
Before we dive into the differences between asset allocation and diversification, their importance in managing investment risk, and how they work together to create a balanced portfolio, we need to define what each of these strategies means.
What is Asset Allocation?
Asset allocation refers to the strategy of dividing an investment portfolio among different asset categories such as stocks, bonds, alternatives, and cash.
The primary goal of asset allocation is to balance risk and reward by apportioning a portfolio’s assets to around an investor’s specific risk tolerance, goals, and investment horizon.
Risk Tolerance
Gauging an investor's tolerance for risk is often the first step in developing an asset allocation and involves assessing one's ability and willingness to lose some or all of an investment in exchange for greater potential returns. Risk tolerance varies significantly from one investor to another and tends to decrease over time, especially during retirement.
Goals
Once your risk assessment is complete, the next step is to determine your goals, then align your money with them. Whether you're saving for retirement, buying a vacation home, or funding your kids' education, establishing clear investment objectives is an essential step in the asset allocation process.
Investment Horizon
Lastly, it's important to consider the length of time an investment must be held before distribution. Longer investment horizons permit a more aggressive asset allocations, whereas shorter durations lasting a few years or less warrant a more conservative investment approach.
Asset Classes
After you've determined your level of risk and defined your goals and time horizon, it's now time to put your money to work in the market!
The market is broken down into a handful of categories of investments with varying degrees of risk and return, otherwise known as asset classes. There are four primary asset classes for investors to consider:
Stocks (Equities): Ownership in publicly traded companies that can provide higher potential returns, albeit with higher levels of risk.
Bonds (Fixed Income): Debt instruments issued by governments and corporations that pay interest to investors and are less volatile than stocks.
Alternatives: A fairly broad category of investments that don't directly correlate with stocks or bonds such and include commodities, long/short strategies, managed futures, global macro and structured products.
Cash and Cash Equivalents: Think savings accounts, money market funds, and Treasury bills which provide liquidity and nearly zero risk.
Monitor and Review
Once your mix of stocks, bonds, cash and alternatives has been established, it's important to remember that your current allocation is not set in stone. The only constant in life, the economy, and the stock market, is change. As such, you should be actively reviewing and monitoring your asset allocation and making the necessary adjustments to your percentages throughout your lifetime.
Now that you have a better idea of what asset allocation is, let's talk about diversification.
What is Diversification?
Although a portfolio mix of 60% stocks and 40% bonds may be the right asset allocation for you, that doesn't necessarily mean you're diversified, especially if all of your 60% equity exposure is in the S&P 500 with the other 40% in treasury securities.
Diversification expounds upon asset allocation and involves spreading investments within each asset class across various sectors, industries and other categories to further mitigate portfolio risk by reducing exposure to any single asset. In short, it's not having all your eggs in one basket.
Just like there are several asset classes to consider for asset allocation, there are various strategies to consider when diversifying your investments:
Ways to Diversify
Company Size (Market Capitalization): Size matters when investing in the stock market. For example, mega-capitalized stocks like Apple are more financially stable than small-cap stocks, which tend to have higher amounts of debt and are more susceptible to large swings in price, both to the upside and the downside.
Geography: The world economy is much larger than the United States, and it's important to consider thw world's geographic locations when investing in stocks and bonds, i.e. developed international markets and emerging markets.
Sector: From technology and utility stocks to energy companies and banks, no one sector moves in lockstep with another, and being overexposed to one industry can significantly impact volatility and returns within your portfolio.
Investment Style: Stocks exhibit varying patterns of risk and return depending on their classification. For example, growth stocks like Nvidia tend to pay less dividend income in exchange for a higher potential price return, whereas value stocks like Proctor & Gamble often yield more income in exchange for slow, moderate growth.
Management Style: If you're investing in funds as opposed to individual securities, you'll be able to diversify your strategy between investment styles aimed at outperforming the market (active mutual funds) or ones mirroring the index (passive exchange-traded funds and index funds)
Manager: Management style can be further diversified based on the portfolio manager or institution running the strategy. Vanguard, BlackRock and J.P. Morgan are just a few of the thousands of professional asset managers to choose from.
Maturity: Relating more to fixed income, spreading your risk across bonds with varying maturities will help reduce price volatility resulting from changes in interest rates.
Asset Allocation and Diversification and Working Together
Both asset allocation and diversification involve spreading risk across different parts of the financial markets and are essential when crafting an investment strategy. Here’s how they can complement each other and aid in portfolio construction, risk management, and helping you achieve your financial goals:
Portfolio Construction
Asset Allocation: Establishes the broad structure of the portfolio by determining the percentage of capital allocated to each asset class, ensuring it aligns with the intended asset allocation.
Diversification: Builds on this foundation by selecting a diverse range of investments within each asset class to spread risk.
Risk Management
Asset Allocation: Manages systematic risk (market risk that affects all assets) by balancing high-risk and low-risk asset classes.
Diversification: Manages unsystematic risk (specific to individual assets) by spreading investments across a variety of assets within each class.
Achieving Financial Goals
Asset Allocation: Aligns the portfolio with the investor’s financial goals, risk tolerance, and time horizon.
Diversification: Enhances the resilience of the portfolio, helping to ensure that it can withstand market fluctuations and achieve long-term goals.
Practical Steps Implementing Both Asset Allocation and Diversification Strategies
Now that you understand how the two strategies work together, here are five steps to help you implement a diversified investment strategy:
Step 1: Risk Assessment
Conduct a risk assessment to understand your comfort level with potential losses. There are several free questionnaires available online to help you determine your optimal mix of stocks, bonds, cash and alternatives.
Step 2: Establish Goals and Your Investment Horizon
Define your financial goals, such as retirement, buying a home, or funding education, and determine the length of time you'll be investing before taking a distribution.
Step 3: Allocate Your Money Across Asset Classes
Based on your risk tolerance, goals, and time horizon, decide on the appropriate mix of asset classes. For example, a conservative investor might choose 40% stocks and 60% bonds, while an aggressive investor might opt for an 80/20 mix.
Step 4: Diversify Within Your Asset Classes
Select the investments (i.e. stocks, mutual funds, bonds, etc.) to fill each asset class while being mindful of your options for diversification. This might include assessing different equity sectors, company sizes, investment styles, and maturities to achieve a well-diversified portfolio.
Step 5: Monitor and Review
Periodically review and rebalance your portfolio to ensure it remains aligned with your asset allocation strategy.
When rebalancing, ensure you're adjusting your holdings on both a macro (asset allocation) and micro (diversification) level by buying or selling assets to maintain the desired targets. For example, if your stock allocation has outperformed and now makes up a larger percentage of your portfolio, you may need to sell some stocks and buy bonds to return them to your target allocation. The same goes for rebalancing to targets set on industry exposure, company size or geographic location.
Bonus: Asset Location Can = Tax Savings
In addition to asset allocation and diversification, there's a third strategy that can add another layer of value to your portfolio in the form of tax savings.
Asset location is an investment strategy that involves placing different types of investments in the most tax-efficient accounts to optimize after-tax returns.
This approach considers the tax treatments of different investment accounts, such as taxable (brokerage) tax-deferred (IRA), and tax-exempt accounts (Roth IRA), as well as the tax consequences of owning investments with varying tax structures like mutual funds and ETFs.
To help illustrate, here is a breakdown of the three main types of investment accounts and the corresponding investments best suited to achieve tax efficiency:
Taxable Accounts - Brokerage
If you're in a high tax bracket, you'll want to closely monitor interest, dividend and capital gain income from your investments in a brokerage account as all will be subject to income tax.
❌ What to Avoid
Mutual funds with high turnover as they can trigger capital gain distributions reportable as income on your tax return.
High-yielding investments like REITs or closed-end funds, especially if you don't need the income.
Commodities like gold as long-term capital gains can be taxed as high as 28%.
✅ What's Ok
ETFs or individual securities. Dividends and capital gains are sometimes unavoidable so if you do have assets yielding income, or have to take gains, favor qualified dividends and long-term capital gains (holding period of one year or more), both of which are taxed at lower rates.
Municipal bonds as interest income is exempt from federal tax.
International equities as foreign taxes incurred on these investments can be claimed as a tax credit.
Tax-Deferred Accounts - IRA and 401(k)
You have more flexibility with investments held in a tax-deferred account as investment income and capital gains are tax-deferred until withdrawal.
❌ What to Avoid
Tax-exempt or deferred investments as they lose their primary benefits as they're already in a tax-deferred account, i.e. municipal bonds, annuities.
✅ What's Ok
Mutual funds, ETFs, index funds, individual stocks, and bonds; all are fair game.
Tax-Exempt Accounts - Roth IRA and Roth 401(k)
Roth accounts are great for investments expected to appreciate significantly, as withdrawals are tax-free (provided certain conditions are met) and investment horizon long as investors generally tap Roth assets last in retirement.
👌 What to Consider
Be sure to consider equities and investments with growth characteristics.
By strategically locating assets, you can minimize taxes and enhance the overall growth of your portfolio. This strategy complements asset allocation and diversification, providing a holistic approach to managing an investment portfolio effectively.
The Role of a Financial Professional
While some investors can manage asset allocation, diversification and location on their own, seeking professional advice can be beneficial, especially for those with complex financial situations or limited investment experience. Financial advisors can provide valuable insights and help tailor strategies to individual needs. Fiduciaries, especially those with tax credentials, can be particularly helpful as many investments can impact your taxes.
Benefits of Professional Advice
Expertise: A financial professional has the knowledge and experience to develop sophisticated asset allocation and diversification strategies.
Customization: Advisors can create personalized investment plans that reflect your unique goals, risk tolerance, and time horizon.
Monitoring: Professional advisors can continuously monitor your portfolio and make adjustments as needed to keep it aligned with your financial objectives.
Conclusion
Careful consideration of one's investment strategies with include asset allocation, diversification, and location are essential components of a sound investment strategy. Asset allocation focuses on distributing investments across different asset classes to balance risk and reward, while diversification aims to spread risk within each asset class by investing in a variety of securities.
Together, these strategies work to create a balanced portfolio that can weather market fluctuations and help investors achieve their long-term goals. By understanding and implementing both asset allocation and diversification, you can build a resilient investment portfolio that maximizes returns while managing risk effectively.
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