I’m sure you’ve heard the terms “asset allocation” and “diversification” used in the same sentence, but they are very different concepts that every investor should understand.
Asset allocation refers to dividing money among different asset classes, such as stocks, bonds, and cash alternatives. These asset classes have different risk profiles and potential returns.
The idea behind asset allocation is to offset any losses from one class with gains in another, thereby reducing overall risk in the portfolio (remember that asset allocation is an approach to help manage investment risk, but it does not guarantee protection from investment losses).1
On the other hand, diversification entails how your money is placed within an asset class. For example, let’s say a hypothetical stock portfolio included a computer company, a software developer, and an Internet service provider. Although the portfolio holds three companies, it may not be considered well-diversified because all the firms are connected to the technology industry. However, a hypothetical portfolio that includes a computer company, a drug manufacturer, and an oil service firm may be viewed as more diversified.1
(Again, much like asset allocation, diversification is an investment principle designed to manage risk, but it does not guarantee protection from losses.)
To some, the differences between asset allocation and diversification are subtle, but they are critical concepts to understand when building an investment portfolio. Feel free to reach out to me if you have any questions—that’s what I’m here for.
- Investor.gov, 2021