You’ve finally decided that, as part of your New Year’s Resolutions, you’ll start investing in 2024.
Congratulations! That’s a wise move, and it’s something that three in four Americans say they’ll also make this year.
As someone new to investing, one of your priorities should be understanding the terminology. In particular, the terms asset allocation and diversification. While these two work hand in hand, they’re not synonymous or interchangeable.
To that end, we created this asset allocation vs. diversification comparison guide. So, read on, as you can use what you learn here to make sound decisions and reach your investment goals.
Asset Allocation vs. Diversification: The Chief Differences
Both asset allocation and asset diversification revolve around asset classes. The latter is a term that refers to a group of comparable or similar financial securities.
Traditionally, there were only three primary asset classes: cash, equities (stocks), and fixed income (bonds). That has since grown to include real estate, futures, commodities, and even cryptocurrencies.
Asset allocation refers to how much of your portfolio you invest in those asset classes. You’ll often see it expressed in percentage. For example, it could be 30% stocks, 30% bonds, 30% real estate, and 10% cash.
Diversification means spreading your assets over different investments in each asset class. For example, your portfolio’s stock portion may consist of income, penny, and IPO stocks. As for your bonds, they could include corporate, treasury, and municipal bonds, to name a few.
You can imagine each asset allocation as a basket to put your “eggs” (AKA your money). So, you have a separate basket for each class, such as cash, stocks, bonds, commodities, real estate, etc.
Now, imagine asset diversification as several dividers inside each of your baskets. One section is for high-risk, high-yield assets. Another is for mid-risk, mid-yield investments, while the third is for the low-risk, low-reward ones.
Why Is Asset Allocation Crucial?
Asset classes, including the three primary ones, generally don’t move in the same direction. Neither are their fluctuations or movements simultaneous.
For example, market conditions that force stocks to plummet often cause another to perform as usual or, sometimes, even better.
You can take advantage of that through asset allocation. This can help maximize returns while meeting your risk tolerance. The latter is the amount of market risk you’re comfortable with.
So, investing in multiple asset classes can help reduce your odds of losing all your money when one of your investments fails. When your investments in other classes perform better, they can counteract your losses.
The Difference Allocation Can Make
If you don’t allocate and instead put all your eggs in one basket, you risk losing many, if not all, of your assets.
Let’s use the disastrous 2022 performance of the stock market as an example. Back then, plunging markets resulted in Americans losing over $9 trillion in wealth.
Now, imagine that you were a stockholder of those fallen stocks. Let’s also say that 100% of your portfolio was in stocks. In this scenario, their falling would have likely cost you most or all of your money.
You’d still have suffered losses if you had invested in different asset classes. However, they wouldn’t be as bad since not all had poor performance in 2022. For instance, returns on real estate investments rose steadily until May 2022.
With allocation, you can boost your chances of having some investments that yield returns. So, even if your other assets don’t, or they lose value, those that do can help even or minimize your losses.
What About Asset Diversification?
Asset allocation alone may not be enough to protect you from losses. It may not help you achieve desirable returns, either. For instance, putting all your money into a low-risk asset in each class may result in inadequate returns.
Enter diversification.
Diversification can lower your risk of losses by spreading assets over low-, mid-, and high-risk assets in different classes. It can also help you reach your financial goals by generating investment income.
Here are some investment strategies for diversifying your portfolio.
Stocks
Stocks are often riskier than other assets, such as bonds, since they offer no guaranteed returns. Bonds, on the other hand, offer returns as fixed income.
The fact that they’re inherently riskier is enough reason to invest in multiple stocks. You can diversify by owning some from small, medium, and large-sized companies. You can further spread your assets by investing in various sectors (e.g., healthcare, technology, and services).
Bonds
Although bonds are generally safer than stocks, they can still be risky. For instance, if the company you buy the bond from goes bankrupt, they may not have enough to pay your interest. They’ll likely be unable to return your money, too.
For that reason, you should diversify your portfolio by getting bonds from different issuers. Generally, the safest are those from the federal, state, and local governments. You can further spread your assets by purchasing bonds from corporations with high credit ratings.
Commodities
Commodities are raw materials consumed directly (e.g., food) or used for other products (e.g., oil and precious metals).
If you want to invest in commodities, you can buy and sell oil futures.
Oil futures yield high rewards. But that’s because they’re also high-risk, considering they’re volatile. So when they do well, you can score big, but when they fail, you can also lose a lot.
You can mitigate that risk and create a more diversified portfolio if you buy gold coins. Gold doesn’t deliver high returns but is generally low-risk and a hedge against inflation. So, even if it doesn’t make you big bucks, it will still make you some; plus, it holds its value pretty well.
Time to Boost Your Investment Portfolio
And there you have it, the differences between asset allocation vs. diversification.
Just remember that allocation means to spread your assets over different classes. By contrast, diversification spreads your money over various types of assets in each class.
Either way, both are vital strategies that work in tandem to help you maximize profits. So, as early as today, consider allocating and diversifying your portfolio.
For more tips like this, check out our recent investment news and guides!
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