Asset Allocation and the Benefits of Diversification

When discussing investing, there are two basic concepts that will get discussed a great deal and are significant to long term success – diversification and asset allocation. Diversification helps manage an investor’s investment risk by limiting exposure to any one investment or one investment type while asset allocation is selecting the correct mix of various asset classes to reach your long-term goals while balancing risk and return.

Learn the importance of diversification:

You probably have heard the old saying about risk advising one not to put all of your eggs in one basket. Diversification is the process of investing in many different securities to help manage this risk of loss. The thought being that if some of your investments perform poorly you will have others that hold steady or rise in value. When financial professionals refer to asset allocation, they're usually talking about overall classes: stocks, bonds, and cash or cash alternatives. However, there are others that also can be used to complement the major asset classes once you've got those basics covered, including alternative investments such as hedge funds, private equity, private debt, metals, and real estate.

Also, diversification should be done within the asset classes. In stocks, that means investing in both domestic and international while also having different size companies (small, mid-cap, and large-cap stocks). For bonds’ investments, you can allocate to different maturities that include both short-term and longer dated bonds along with different issuers including corporations and governments.  

Explore the utilization of asset allocation:

Asset allocation is a strategic approach to diversifying your portfolio among different asset classes that seeks to pursue the highest potential return within a certain level of risk. One must consider their investment goals, time horizon, and risk tolerance, before investing different percentages of your portfolio in targeted asset classes to pursue your goals. A careful analysis of these three personal factors can help you make strategic choices that are suitable for your needs.

Each type of investment has specific strengths and weaknesses that enable it to play a specific role in your overall investing strategy. Some investments may be chosen for their growth potential while others may provide regular income.

Generally speaking, if you have a high-risk tolerance and a long-time horizon to meet your retirement goals, you will be using a more aggressive strategy that allocates a higher percentage to stocks which historically have higher average returns but also increased volatility when the market takes a downturn.

On the other hand, if you have low tolerance for risk or are living on fixed income, you will want to use a more conservative approach and allocate a larger percentage of your asset mix to income-producing securities, such as bonds, that are not as volatile and pay regular income. There are many publications that feature model investment portfolios that use generic asset allocations based on age. These can be a way to gain knowledge and start thinking about your asset allocation, but these are based on averages and hypothetical situations. Your asset allocation should be your own, as even people who are the same age and incomes may have very different goals and needs.

Things to consider regarding asset allocation:

Don't forget about the impact of inflation on your savings. As time goes by, the cost of things will continue to rise, and your money will buy less and less unless your portfolio at least keeps pace with the inflation rate. Even if you think of yourself as a conservative investor, your asset allocation should take long-term inflation into account.

Your asset allocation should balance your financial goals with your emotional needs. If the way your money is invested, makes you uncomfortable and unable to sleep at night, you may need to rethink your investing goals and whether the strategy you're pursuing is worth the lost sleep.

Your tax status might affect your asset allocation, though your decisions shouldn't be based solely on tax concerns.

Also, understand that you will need to reevaluate your asset allocation over time as your circumstance changes.

If you have any questions or concerns, please reach out to your First Bank Wealth Management Team.