by Frederick A. “Rick” Fisher, MS, CFP®
Have you heard the financial terms “Asset Allocation” and “Diversification” and been slightly puzzled? Financial professionals often use these terms without much explanation. Jargony concepts like these can make investing seem more intimidating and complex than it really is.
These abstract terms refer to very simple concepts that can have a big effect on your investments. Both terms refer to investment strategies that aim to decrease risk, but they work in slightly different ways. It’s important to understand the two concepts and make sure that your portfolio is healthy by both measures.
Asset Allocation
Different types of investments are grouped into categories called “asset classes.” You are probably familiar with the main asset classes:
Cash
Equities (stocks)
Fixed income (bonds)
Real Estate
Since these asset classes may behave differently in certain market conditions, by including different asset classes in your portfolio, you may lower overall risk. A portfolio with proper asset allocation includes each of these four asset classes. The actual proportion invested in each asset class depends on the individual investor’s circumstances.
Diversification
One familiar adage that refers to diversification is “don’t put all of your eggs in one basket.” The aim of diversification is to decrease the total risk in a portfolio by spreading the money over many smaller investments. By investing in instruments that do not move up and down together, the overall risk of a total diversified portfolio is lower than the risk of each individual investment within the portfolio.
Asset Allocation Without Diversification
While asset allocation is important, it’s also important to diversify within each asset class to reduce risk. To illustrate, imagine that Ted and Alice have a $500,000 portfolio that consists of the following:
$20,000 in cash
$80,000 in a California Municipal Bond
$200,000 in Chevron stock
$200,000 in a vacation home rental
Since the portfolio includes all four asset classes, it is technically well allocated. However, the portfolio is not well diversified because all of the stock is invested in one company’s stock. Similarly, the bond holdings are in one bond and their real estate consists of one single family home.
To adequately diversify this portfolio, they could sell most of the Chevron stock and purchase other stocks in other industries or a mutual fund that includes stock in many companies. Likewise, the bond may be sold and the proceeds used to purchase a mix of bonds from different cities and States.
Diversification Without Asset Allocation
To illustrate the opposite scenario, let’s say we have a new prospect named John. His portfolio consists of five different mutual funds. Because mutual funds contain many underlying investments, he believes that his portfolio is well allocated.
However, the mutual funds that he owns happen to be all from the same asset class. One is an index fund based on the S&P 500, made up of stock from large U.S. companies. The other four are top performing US large cap stock funds, which are also made up of stock from large U.S. companies.
His portfolio may be well diversified within the “stocks” category, but it does not contain any other asset classes, so is not well-allocated. To remedy this, he could sell some of his stock mutual funds and invest in bonds, real estate, and cash. He could also diversify further into non-US stocks, as well as Mid Cap (mid-sized company) and Small Cap (small company) stocks.
Why Allocation and Diversification Matter
When creating a strong investment portfolio, it’s important to invest in different asset classes to decrease the risk of each class. It's also important to diversify within each asset class to spread the risk among many investments within that class.
A professional financial advisor can use tools to analyze how your portfolio is invested and make recommendations to improve your allocation and diversification. This may reduce the risk of investing over time and help you feel more confident in your financial future. To review the asset allocation and diversification of your portfolio, call 530-273-4425 or email our office today.
About Rick Fisher
Rick Fisher is a financial consultant offering comprehensive financial planning and investment management with Ostrofe Financial Consultants, Inc. in Grass Valley, California. His goal is to help clients prepare for retirement and pursue their financial dreams in a fun and personal way. Rick serves clients in 15 states, though most reside in California, including the greater Sacramento, Los Angeles and San Diego areas.
Credentials and Experience
Rick holds FINRA Series 7, 63, 65, 24, and 51 licenses and is supported by Ostrofe Financial Consultants and National Planning Corporation. He also holds his California Insurance License and the designation of CERTIFIED FINANCIAL PLANNER™ professional (CFP®). The CFP® designation is awarded to experienced financial professionals who pass an examination and pledge to abide by a strict code of ethics. He holds himself to their high standards of integrity, objectivity, professionalism and confidentiality. Please note: NPC does not render tax or legal advice.
How Rick Can Help
Rick strives to take the fear and stress out of financial planning. He works with clients to uncover financial issues they may not have known about or have not yet addressed. Rick and the Ostrofe Financial Consultants team are there to answer questions, guide clients towards their goals, and help them feel confident in their future. To learn more about how Rick may be able to help, call his office at 530-273-4425.