Assets Allocation and Diversification

The term “asset allocation” is often used to describe the money management strategy that designates how capital should be distributed within an investment portfolio.

Learning Tip

Asset allocation typically involves identifying how much of the portfolio should be distributed into various asset classes, or broad types of investments such as stocks, bonds, commodities, and cash.

Understanding

Asset Allocation

The objective of asset allocation is to optimize the mix of the investments into different asset classes in order to maximize the return of the investment portfolio while minimizing the potential risk, based on an investor’s timeframe, risk tolerance, and long-term investment goals.

Evidence exists that suggests certain asset classes perform better or worse depending on economic conditions, market forces, government policy, and political influence. The goal of an asset allocation strategy is to identify these conditions and allocate resources appropriately.

Utilizing asset allocation strategies as a form of risk management is not a new concept. The idea of “not putting all of your eggs in one basket” is something we learn as children and has been around for thousands of years.

Even before the advent of modern financial markets, people understood that one’s assets should be divided among different classes such as one’s land, the ownership of a business, and reserves (cash). This is called classical portfolio management or theory.

So, now you have basic understanding of asset allocation. let’s look into Diversification.

Understanding

Diversification

A concept that is closely associated with asset allocation is “diversification”, and in practice, these terms are often used interchangeably.

Asset allocation, however, is principally concerned with allocating capital into different asset classes. For example, a typical asset allocation strategy might dictate that your portfolio should have 50% invested in stocks, 30% invested in bonds, 10% in commodities, and 10% in cash.

Diversification is typically associated with the allocation of capital within those asset classes. For example, within the stock allocation of the same portfolio, investments could be allocated to 50% large-cap stocks, 20% mid-cap stocks, 10% small-cap stocks, 10% international stocks, and 10% emerging market stocks.

The concept of diversification involves the distribution of assets within individual asset classes – while risk is distributed among the asset classes of the overall portfolio, diversification reduces risk within each asset class.

Understanding

Limitations of Asset Allocation

Even with all of the benefits it provides, using asset allocation as a risk management strategy has limitations. Being aware of these limitations will help investors realize when other tools may be used to minimize risk in their portfolios.

One major criticism of asset allocation is that “Black swan” events (unexpected events that have catastrophic consequences) seem to occur more often in the financial markets than would be statistically expected if the markets truly followed a normal distribution.

If this is true, using standard deviation as a measure of risk may be misleading, and statistical correlation between asset classes may be distorted. Also, correlation tends to increase between asset classes during a crisis period, which would make asset allocation less useful as a risk management strategy precisely when it is needed most.

Another criticism of asset allocation is that it does not tell the investor when to buy or sell a security. Buy and sell decisions are based on reallocating the portfolio (usually arbitrarily) when it appears to need rebalancing due to the investor’s risk parameters, without regard to changing market conditions.

Tactical asset allocation strategies can be used to address some of the timing of buy and sell decisions, which are usually not part of strategic asset allocation investment decisions.

Finally, asset allocation as a risk management tool does not address the risk of portfolio drawdown. Drawdown is defined as the minimum value of a single investment or investment portfolio reached following a previous peak in value. During secular bear markets, portfolio drawdown can be significant.