When it comes to investing, you’ve likely heard a lot about two terms: asset allocation and diversification. While both are linked, each has a different definition and meaning to your investment strategy.
Asset allocation refers to the overall mixture of your portfolio, or in other words, in which asset classes you’ve invested. Diversification means that you’ve spread your funds across these asset classes in a way that is most likely to meet your goals.
A few things come to mind in building portfolios.1. It’s important to understand your investment goals
Before you can start investing, you need to understand your end goals and how soon you need to meet them. A grandparent investing for the education of his teen-age grandchildren will have different needs than a recent college graduate taking part in a 401k for the first time.
Other factors come into play here as well, such as your available cash flow, sources of income, debts and other investments, so looking at the big picture is important.
2. Allocating assets is a personal matter
Assets are grouped into one of five classes: cash, bonds, equities, real estate and alternatives. Investments that look and behave in a similar fashion are put into the same asset class.
For instance, cash assets are just what the name implies, currency accounts that can be withdrawn from immediately or held for a predetermined amount of time, usually with greater interest. This type of investment is considered the most secure and a good bet if you’re going to need access to the funds in the near future.
On the other hand, equities are stocks or shares representing ownership in a company. Equities can generate higher returns over the long term when compared to cash, but experience greater short-term volatility as share prices rise and fall.
Your timeline plays a big part in determining your risk tolerance and whether you’d be better off investing aggressively or taking advantage of assets, such as cash accounts, that have more sure returns. This asset allocation is a major determiner of how likely you are to meet your goal, so selections should be made according to your personal needs and with a view of your complete financial situation.
3. Diversification helps to mitigate risk
In the 1990s, the nascent tech boom spawned a number of high performing companies. Early traders in many of these stocks realized high returns, but when the bubble burst and several of those companies failed, investors were left holding the bag—an empty bag.
With this example, it’s easy to see how putting all of your investments in a single asset class, such as stocks, can be a high-risk strategy. It also serves to highlight the necessity of diversifying not only across asset classes to ensure a mix of cash, bonds, equities, real estate and alternatives, but how important it is to diversify your portfolio within each class.
In the 1990s, investors holding stocks in tech companies may have mitigated some of the risks by investing in companies from other industries and by spreading funds across the five asset classes.
4. Consider the long term
No matter how you select your assets and diversify within asset classes, there will be market volatility. Part of weathering the ups and downs is sticking to your strategy.
We are often asked if various conditions, such as elections, make a good time to pull back on some riskier investments or leave the market entirely. Unfortunately, there is no way to accurately time the market. Even if you should avoid a downturn, you’re likely to miss returns on the other side when the market heads back up.
Meeting Your Goals While Minimizing Your Risk
The best investment strategy considers your financial needs and timelines. Investments are then allocated based on the appropriate level of risk for your goals. While understanding asset allocation and diversification is an important part of creating a sound investment plan, factoring for adequate returns is a complicated process, dependent upon a number of aspects.
It’s a good idea to speak with an advisor about your plans and goals. Experienced professionals know which questions to ask to make sure your asset allocation and diversification are aligned to your financial needs.
Remember, you aren’t investing for today or the current market cycle. You’re investing for your future.
About the Author
Kurt Spieler is Chief Investment Officer for First National Bank Wealth Management, where he is responsible for developing and implementing investment strategies. This includes leading the asset allocation, equity, fixed income and manager research committees. In addition, Kurt manages investment portfolios for high net worth and institutional clients.