Asset allocation and diversification: Here's all you need to know

Diversification and asset allocation are critical components of any portfolio-building project. Some investors, on the other hand, tend to use phrases synonymously. While both aid in portfolio risk management, but let’s understand how much they are different:

What is an asset allocation?

By altering the percentage of each asset in an investment portfolio in accordance with the goals under consideration, investment time frame, and income flows, asset allocation is an investment technique that aims to balance risk and return.

Questions such as how old are you? What are your primary goals and objectives for the short-term and long-term? Do you have a retirement date in mind? How much money do you manage to save? And how much money do you think you’ll need in retirement? It is common for an advisor to ask these questions to their client to identify the optimal asset allocation mix.

As opposed to what you want it to be, most of the time, it is determined by what you need instead. As a result, a financial strategy is devised. Equity, debt, and cash are the three main asset classes, according to conventional wisdom. Real estate, gold, silver, and other precious metals, as well as alternatives like art, coins, and other collectibles, can all be included in your asset allocation.

For instance, a person in his 30’s might have a different asset allocation than a person nearing his retirement. That said, asset allocation does not have a specific guideline and depends on the needs and wealth of the investor.

That said, the core meaning of asset allocation is that you may minimise portfolio volatility and improve risk-adjusted return measures by mixing assets that are not highly correlated.

What is diversification?

Is portfolio risk fully addressed by asset allocation? What if you put all of your money into a single stock or mutual fund? Consider an investor ‘A,’ who owns a single stock, whereas investor ‘B,’ owns 20 different stocks.

As a result, if ‘A’ experiences a setback due to disappointing profits, or a decline in revenue, his portfolio could take a significant hit. In financial jargon, this is referred to as non-systematic risk. Diversification across stocks reduces this risk.

On the other hand, investor ‘B’ will be less affected by a single company’s problems because he owns 20 other equities. Even if one of his stocks went bad, it would only have a tenth of an impact on his entire portfolio.

On the other hand, systemic risks can affect all stocks at once, such as a recession. Risks linked with the market as a whole (also known as market risk) cannot be eliminated by diversifying within that market.

Investing in more than 20-30 stocks does not make sense when it comes to diversification. If you’re using mutual funds, 4-5 funds per asset class should be sufficient. You may have a combination of large-cap and mid-cap funds, for example, within an asset class of equities funds. Again, your age, goals, and investing capacity will all play a role in this.

Further, diversification is only effective to a certain extent. When you have too many stocks or funds in your portfolio, growth is mediocre, and the quality of your portfolio suffers as a result.

Diversification deals with the concentration of your portfolio’s different types of assets, whereas asset allocation provides a comprehensive picture and plan. To minimise risk and maximise profits, it’s critical to have a well-diversified investment portfolio, no matter what stage of life you are in.