Diversification is used to reduce an investor’s exposure to the risk of a particular asset class or security. By diversifying, an investor is less likely to suffer a major loss compared to what the risk would be if the portfolio was concentrated in a single asset or security. Diversification is a technical topic but here are two basic concepts that every investor should be aware of: asset allocation and security selection.
What is Asset Allocation?
Asset allocation is determined once an investor figures out his or her risk-return profile, along with their objectives and unique circumstances and constraints in the investment policy statement. The allocation outlines what type of assets and in what proportions the portfolio should be invested in. This step comes before security selection; before you pick your individual investments.
For example, an investor who has a short-term time horizon and is close to retirement should consider allocating his or her money in asset classes that have low-volatility and fixed returns. In this case, the investor should choose mostly fixed income and money market securities as the main asset classes of choice. Notice how we didn’t specify which securities they should consider but rather only the type of asset. Choosing the actual stock or bond or other investment holding is part of security selection.
Before we go further, let’s briefly describe what an asset class is. An asset class is a term that describes a group of investments that behave in a similar manner during market or economic events. These include equity (stocks), fixed income (bonds), commodities, real estate, preferred stocks, and other alternative assets. These are all different types of assets. An individual asset class can be thought of as a family of investments, much like your family, you have similar genes, DNA, and possibly share the same traits and characteristics.
Diversifying Across Multiple Asset Classes
Asset allocation involves diversifying your portfolio across multiple asset classes. The reason this is important is because different asset classes have varying risk-return profiles, they have a low correlation to one another, and holding multiple types of assets provides a more favorable return for a given level of risk (i.e. it improves the overall portfolio sharpe ratio).
For example, suppose you have a portfolio with an asset mix of:
- 60% equity
- 30% fixed income
- and 10% real estate
What this means is that 60% of your portfolio is invested in the equity asset class (stocks), 30% in fixed income (bonds), and 10% in real estate. Now, suppose there is a big market crash or correction. In this case, generally, most stock prices go down, while bond prices rise. That’s due to investor fear and flight to safety. Because bonds and stocks have low correlation or even negative correlation in some cases, your portfolio losses are not as bad as they would have been had all your holdings been in stocks at the time of the crash.
Asset allocation accounts for most of the portfolio returns. In other words, it matters less which exact holdings you have in your portfolio. What matters more is the type of assets your portfolio is comprised of. For example, if all your holdings are 100% equity, the fact that they’re equity matters more than whether you invest in the SPDR S&P 500 Index (SPY) or iShares Core S&P Mid-Cap ETF (IJH).
Once a portfolio’s asset allocation is determined, an investor needs to select securities or pick the actual individual portfolio holdings. Let’s go back to our previous portfolio example:
- 60% equity (stocks)
- 30% fixed income (bonds)
- 10% real estate
In this case, an investor needs to pick securities for each asset class. So 60% of the portfolio needs to be allocated to picking stocks or securities that invest in stocks. This could include mutual funds or exchange-traded funds that hold a portfolio of stocks. The benefits of these fund investment vehicles is that they provide instant diversification through just one or a few funds.
To make up that 60% of your portfolio, you can also be stock picking. When considering what stocks to buy, it would be wise to look at fundamental and technical factors. How to pick the best stocks is beyond the scope of this article but we’ll discuss it in upcoming topics.
Same goes for your other assets, you’ll need to pick funds or individual bonds to make up 30% of your portfolio. While the last 10% can be invested in REITs, actual real estate properties, land or other real estate investments. Read about the 6 common ways of investing in real estate here.
Just to recap, asset allocation determines what type of assets your portfolio should be made up of and in what proportions. Whereas, security selection is the process of actually picking the individual holdings in your portfolio that make up the asset allocation in the right proportions. Both of these are important in the portfolio creation process. However, generally speaking asset allocation has a bigger impact on portfolio returns than security selection.