"Don't put all your eggs in one basket." That timeless adage tidily sums up the concepts of asset allocation and diversification.
When it comes to investing, asset allocation is the equivalent of deciding how many of your eggs you're going to put into how many different baskets—or asset classes. Diversification is the spreading of your investments both among and within different asset classes. And rebalancing means making regular adjustments to ensure you're still hitting your target allocation over time. All are important tools in managing investment risk.
These strategies are all about variety. If done well, asset allocation, diversification and rebalancing should help generate a healthy blend of performance and risk protection for life.
The first step is deciding on an asset allocation. Usually expressed on a percentage basis, your asset allocation is what portion of your total portfolio you'll invest in different asset classes, like stocks, bonds and cash or cash equivalents. You can make these investments either directly by purchasing individual securities or indirectly by choosing funds that invest in those securities. Other asset classes some investors consider include options, futures and commodities, real estate and more.
Different categories of investments respond to changing economic and political conditions in different ways. By including different asset classes in your portfolio, you increase the probability that some of your investments will provide satisfactory returns even if others are flat or losing value.
Your asset allocation will depend on a number of factors, including your risk tolerance and your investment horizon. You may also have a different target asset allocation for different accounts. For example, you may invest more heavily in cash or cash equivalents in your down payment fund if you're getting ready to buy a house, while simultaneously investing more heavily in stocks in your retirement fund if retirement is still decades away.
Asset allocation alone is not enough to effectively manage risk. After all, allocating 100 percent of your assets into security in one asset class won’t offer up much protection. Instead, it will expose you to concentration risk. That’s where diversification comes in.
Diversification reduces the risk of major losses that can result from over-emphasizing a single security or single asset class, however resilient you might expect that asset or asset class to be. This is especially true if your assets are "uncorrelated," meaning they react to economic events in ways independent of other assets in your portfolio. Stocks and bonds, for instance, often move in different directions from each other, which is why holding both of these asset classes (and others) can help manage risk. Learn more in this Smart Investing Course: Playing the Field: Diversification.
Financial experts tend to recommend diversification among and within asset classes. For example, when it comes to stocks, diversification increases when you own multiple stocks. It increases further when those stocks are made up of different sized companies (small, medium and large companies), include different sectors (technology, consumer, healthcare and more) and are diversified geographically (domestic and international).
Similarly, if you're buying bonds, you might choose bonds from different issuers—the federal government, state and local governments and corporations—as well as those with different terms and different credit ratings.
Building a diversified portfolio is one of the reasons many investors turn to pooled investments—such as mutual funds and exchange-traded funds. Pooled investments typically include a larger number and variety of underlying investments than you're likely to assemble on your own, so they help spread out your risk. You do have to make sure, however, that even the pooled investments you own are diversified. For example, owning two mutual funds that invest in the same subclass of stocks won't help you to diversify.
Role of Rebalancing
As market performance alters the values of your asset classes, you may find that your portfolio no longer provides the balance of growth and return that you want. In that case, you may want to consider adjusting your holdings to realign with your original allocation.
Although there’s no official timeline that determines when you should rebalance your portfolio, you may want to consider whether you need to rebalance once a year as part of an annual review of your investments.
Keep in mind that account shifting means potential sales charges and other fees. Aside from the costs you might incur, switching out of investments when the market is doing poorly means locking in your loss. If this occurs in a taxable account, you may be able to take a tax deduction, but that’s not the case with tax-advantaged retirement accounts. Also, be aware that if your investments have increased in value, selling them to rebalance your portfolio in a taxable brokerage account could result in your having to pay capital gains taxes.
You can rebalance your portfolio in different ways. Three common approaches include:
- redirecting money to the lagging asset classes until they return to the percentage of your total portfolio that they held in your original allocation;
- adding new investments to the lagging asset classes, concentrating a larger percentage of your contributions on those classes; and
- selling off a portion of your holdings within the asset classes that are outperforming others. You may then reinvest the profits in the lagging asset classes.
All three approaches work well, but some people are more comfortable with the first two as they may find it hard to imagine selling off investments that are doing well in order to put money into those that aren't. Remember, though, that if you invest in the lagging classes, you'll be positioned to benefit if they turn around and begin to prosper again.
Another approach some investors take is to invest in lifecycle funds, also called target date funds, which are designed to have their allocation modified gradually over a period of years, shifting its focus from seeking growth to providing income and preserving principal. Learn more about target date funds.
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