What is the difference between asset allocation and diversification?

Asset allocation means choosing and investing in assets according to your risk profile and goals. Asset allocation involves distributing a portfolio among various types of assets, such as equity funds, debt funds, gold, and more. The best asset allocation for an investor depends on priorities. This means looking at their age, time horizon and their risk profile.

Let’s understand this with an example. Gaurav is a 30-year-old young individual. So, according to the rules, he should primarily invest most of his money in equity mutual funds because he has a lot of time to earn higher returns, and he can afford to take more risks. He can also consider some investments in debt mutual funds.

On the other hand, Saurav is a retired investor at the age of 60. He should aim to invest only a small portion of his money in equity mutual funds because at this age, he may not want to take excessive risks, and he needs more stable returns.

So, what should be the ideal asset allocation for a 30-year-old individual?

Asset allocation varies across different phases of life. In the initial phase, one needs to prepare a financial plan. This plan should determine the investor’s financial goals, such as how much corpus they need and what their time horizon is—meaning, how long they can invest.

The investor also needs to consider how much risk they are willing to take to achieve their goals. Asset allocation can be adjusted based on their risk-taking ability.

For example, due to the potential for higher returns in the long term, equity investments are good, but they can be more volatile in the short term. On the other hand, investing in debt funds may be more beneficial for short-term goals because they tend to have lower volatility over shorter periods. This can result in a more consistent return while preserving capital.

Now, let’s talk about what diversification means. In the world of investments, there’s an age-old saying: “Don’t put all your eggs in one basket.” This simply means that as an investor, you should introduce diversity into your investment portfolio so that the impact of market fluctuations on your portfolio returns is minimized.

Investing 100% of your funds in any single type of asset, whether it’s debt or equity, can be risky. If a particular fund or security doesn’t perform well, you could incur significant losses. The simple concept of diversification means spreading your risk across different asset classes and a sufficient number of schemes or securities.

Shweta Jain, the founder of Investography and a Certified Financial Planner (CFP), emphasizes that asset allocation is crucial so that your money grows while also being available for your needs or goals. On the other hand, diversification ensures that you don’t place too much risk on a single product or company. This way, even if a company fails, it won’t have a disproportionately large impact on your portfolio.

For any investor, it’s essential to have an appropriate asset allocation for each financial goal. The most crucial ground rule is to adopt an asset allocation strategy that diversifies your investments across various asset classes like equity, debt, and gold. Incorrect asset allocation can always have an impact on returns, especially in the long term.

Once you have gathered all the information and made your choices with understanding, you should stay focused and maintain your investments. Periodically review your portfolio. When it comes to selecting mutual fund schemes, the best approach is to seek the assistance of a financial planner or advisor.