Asset allocation and diversification are nothing short of essential when constructing a portfolio. Some investors, though, tend to use these terms interchangeably. While both help with managing portfolio risk, how exactly are the two related?
Asset Allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio, according to the goals under consideration, the investment time frame and the income flows.
A financial advisor would typically ask the following questions to determine the appropriate asset allocation mix for his retiring client:
• What is your age?
• When do you plan to retire?
• How much do you save?
• What is your income need later in life?
Accordingly, an investment plan is chalked out. It is usually driven by what you ‘need’ rather than what you would ‘like’ it to be. In other words, portfolio risk taken is not a choice but a consequence of your wealth status.
Traditionally speaking, there are three major asset classes – equity, debt and cash. You can also add real estate, precious metals (gold, silver etc) and alternatives such as art, coins and other collectables to the asset class mix.
So, for those approaching retirement, asset allocation could be 50% equities, 30% debt and 20% cash. Or for those in the 30s, it could be 90% equities and 10% cash. There is no standard rule for asset allocation and it differs based on one’s needs and wealth status.
Why invest in different assets?
The basic premise is that by combining assets that are not highly correlated, you can reduce the volatility of the portfolio and improve risk-adjusted return measures. Interestingly, the combined assets need not necessarily be negatively correlated. Even if these assets are volatile by nature, its combined portfolio will still reflect reduced volatility, as long as they are not perfectly correlated.
Historically, it has been seen that the correlation between equities and bonds has been low and they don’t move in the same direction. This in turn has helped reduce risk portfolio for investors owning a hybrid investment portfolio.
Does asset allocation fully take care of portfolio risk? What if you were to invest all your equity investment into one stock or a fund? Imagine investor ‘A’ has a single stock in his portfolio while investor ‘B’ has 20 stocks. So, in the case of ‘A’, events like earnings disappointment, product failure or business loss (for that company) can result in his portfolio taking a huge beating. It’s called non-systematic risk in market parlance. This can be reduced by diversifying across stocks.
In contrast, ‘B’ owns 20 stocks and so any company-specific issue will not impact his portfolio as much since he has diversified across various stocks. One stock going bad would only affect 1/20th of his portfolio.
In addition, there are also systematic risks, which affect all stocks – like from an economic downturn. These risks are associated with the entire market (also called market risk) and cannot be diversified away within that market.
When it comes to stocks, experts believe diversifying beyond 20 to 30 stocks doesn’t make sense. And if you are investing in mutual funds, about 4-5 funds per asset class, would suffice. Within an asset class – say equity funds – you could have a mix of large-cap and midcap funds and so on. This again to some extent will depend on your age, goals and investing capacity.
While asset allocation improves risk-adjusted measures, it has limitations. For instance, it does not work as well as imagined in outlier “fat tail” events or “black swan” events. During these times, prices of all asset classes tend to move in tandem, throwing off most risk-mitigation strategies.
Similarly, diversification works only up to a point. Too many stocks or funds result in mediocre growth and dilution in portfolio quality.
Asset allocation gives an overarching view, and plan, of the different types of assets in your portfolio while diversification deals with the concentration of these assets. Whatever your life stage, having the right mix of investments will be crucial in reducing risk and increasing returns on your portfolio.