Asset allocation and diversification are important concepts in investing. Although many investors think of them interchangeably, they are, in fact separate concepts. Asset allocation refers to how you choose to spread your money among investments. Every investor practices asset allocation by virtue of having invested. Whether or not that asset allocation represents diversification is another matter altogether.
Diversification is a portfolio attribute that can be achieved through asset allocation. The purpose of diversification is to manage risk by investing in many different types of assets. Stocks and bonds from companies of different sizes and from different countries all have places in a diversified portfolio.
There are many considerations in building a diversified portfolio, but here are three decisions that may hinder your quest for ideal diversification.
- Choosing to invest in individual stocks and bonds instead of mutual funds or ETFs. It is difficult to find consensus among experts on the number of stocks or bonds required to build a diversified portfolio, but the numbers generally fall in the 20-50 range for the US stock market alone. Effective diversification requires exposure to international stocks and bonds, as well. For most individual investors, diversifying this way just isn’t practical.
- Using a global fund to fill an international allocation. Global funds may invest in securities from every country in the world, including the one you live in. Some global funds from US companies can invest up to 50% (or more) of their assets in US securities. This may lead to overlap with your domestic investments and make your portfolio less diversified than you intended. If you’re looking for exposure to countries other than the one you live in, go with an international fund. If you’re looking to diversify further, choose a fund with allocations to emerging markets, which don’t correlate as closely to the US as larger countries do. (Keep in mind that emerging markets also add risk, so size your allocation accordingly.)
- Choosing a fund by name alone. Sometimes investors spend a great deal of time determining exactly how they want their portfolios to be allocated, then lose it in the implementation stage. Some, as described above, may end up with far less international exposure than they wanted. Others match their asset allocation goals with fund names that describe asset classes without looking any further. A mid cap fund that behaves like a large cap fund, for example, defeats the purpose of the mid cap allocation altogether. A careful reading of the prospectus will tell you how much latitude is given the portfolio manager for an actively managed fund, and which index is being used to define an asset class for an index fund. Also, a look at a fund’s Morningstar style box will tell you if its name is representative of its current holdings.
Eggs and baskets
Diversification is the embodiment of the old adage about eggs and baskets. Just as important as choosing asset classes, however, is how you choose to invest in those asset classes. A diligent investor looks beyond the theoretical world of indexes to actual investments, making sure they reflect the desired asset allocation
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