Q. I hear the terms asset allocation and diversification, and to me they both mean making sure you have different kinds of investments. Am I missing something?
A. The concepts are similar, but they’re not identical.
When you think “diversification,” you should think, “Don’t put all your eggs in one basket.”
The eggs are your money and the basket is one stock, company or investment, said Reed Fraasa, a certified financial planner with Highland Financial in Riverdale.
“Instead of owning one stock/basket, you own many stocks/baskets and if one stock/basket drops/breaks, you still have many other stocks/baskets that are not broken,” Fraasa said. “That is the concept behind a mutual fund: diversification reduces individual company stock risk by owning dozens or hundreds of similar companies.”
The term “asset allocation” is related to an old idea of spreading your risk among very different types of things, Fraasa said.
“The Talmud, circa 1,200 BC, states, `Let every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep in reserve,'” Fraasa said. “Today we may say keep a part in cash, a part in bonds, and a part in stocks.”
He said there’s lots of academic research and at least one Nobel Prize in Economics attesting to the benefits of asset allocation in a portfolio.
Fraasa said the main idea is not so much that if one asset class crashes you still have two or three others that remain — like in the diversification explanation — but that these three or four diverse asset classes will not move in tandem.
“Thus you can reduce the overall risk in the portfolio by spreading the funds across several diverse asset classes like cash, bonds, and stocks,” he said.
Jerry Lynch, a certified financial planner with JFL Total Wealth Management in Boonton, describes asset allocation as what percentage of stock you have compared to how much you have in bonds. Then diversification is how your money is split into different sub-categories.
For example, Lynch says, let’s assume that your appropriate asset allocation is 60 percent stock and 40 percent bonds. The diversification for stocks may include portions in the following categories: large-cap U.S. stocks, mid-cap U.S. stocks, small-cap U.S. stocks, international and emerging markets.
“It is important to realize that just because you have different mutual funds does not necessarily mean that you are diversified if those funds invest in similar stocks or bonds,” Lynch said.
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