Diversification and asset allocation, explained
“Don’t put all your eggs in one basket” is the short version. The longer version involves two related ideas, asset allocation and diversification, plus a habit called rebalancing. Investor.gov, the SEC’s education site, describes all three in its beginners’ guide.
Asset allocation
Asset allocation means dividing an investment portfolio among different asset categories, such as stocks, bonds and cash. Each category behaves differently. Stocks have historically offered higher returns over long periods but with larger swings. Bonds are generally less volatile but usually offer lower returns. Cash is the most stable but may not keep up with inflation.
The right mix depends on your time horizon (when you will need the money) and your risk tolerance (how much loss you can accept, financially and emotionally). Someone saving for a goal decades away is in a different position from someone who needs the money next year.
Diversification
Diversification means spreading money within each category. Owning shares of one company exposes you to everything that can go wrong at that one company. Owning many companies across different industries reduces that specific risk. Funds that hold many securities, such as mutual funds and exchange-traded funds, are one common way to diversify.
Diversification does not remove all risk. When the whole market falls, most stocks fall together. Investor.gov puts it plainly: diversification and asset allocation do not guarantee a profit or protect against losses in a declining market.
Rebalancing
Over time, some investments grow faster than others, and your mix drifts away from what you planned. Rebalancing means bringing it back, either by selling some of what grew or by directing new money to what lagged. Some people rebalance on a calendar schedule; others do it when an allocation drifts by a set amount. Selling in a taxable account can create taxes, which is worth considering.
A note on costs
Fees reduce returns year after year. When comparing funds, look at the expense ratio and any sales charges, which must be disclosed in the fund’s prospectus.
Key points
- Asset allocation: the split between stocks, bonds, cash and other categories.
- Diversification: spreading risk within each category.
- Neither guarantees a profit or prevents losses.
This article is general information, not investment advice. It does not consider your personal situation. Consider speaking with a licensed financial professional before making investment decisions.
