Asset allocation and portfolio diversification are common investment terms that find their way into most financial journals, and as an investor, you must have encountered them multiple times. It is common among investors to mistake them for the same thing. However, asset allocation and portfolio diversification are two very different strategies.
In case you thought they were the same, it surely will help you to know the following:
What is asset allocation?
Asset allocation refers to the distribution of funds across different asset classes, such as stocks, bonds, mutual funds, cash and cash equivalents, gold, real estate, etc. Optimum asset allocation offers maximized returns and lowers the risk on your portfolio. For instance, stocks are highly volatile compared to bonds. So, having a balanced combination of the two can ensure higher rewards and moderate risk.
The right asset allocation depends on your financial objectives. For instance, if you want better growth with high risk, you can distribute more wealth to stocks. However, if you prefer low risk and low returns, you can allocate more funds to bonds.
What is portfolio diversification?
Portfolio diversification refers to distributing your funds across different investments within an asset class with the ultimate objective of reducing risk. For example, if you are investing in bonds, you can diversify with government bonds, corporate bonds, municipal bonds, etc. If you are investing in mutual funds, you can consider a SIP in an equity mutual fund, another in a debt mutual fund, or a balanced mutual fund. If you wish to diversify mutual funds, you can aim at having 3 to 5 different funds in your portfolio, covering different markets and fund management styles.
When you diversify, you spread the risk across different investments. So, even if one investment does not perform well, the others compensate for its loss. This way, you do not suffer extreme loss. Here’s another example: If you buy 100 pharmaceutical company stocks, you expose yourself to high risk. If the pharmaceutical industry falls, you could face heavy losses. However, if you spread your funds across industries like oil, travel, technology, etc., you lower your risk since no two industries are likely to perform in the same manner.
What are the similarities between asset allocation and portfolio diversification?
Both these investment strategies aim to focus on the primary objective of risk reduction. They also aim to increase your returns. They can help you evade market volatility, bring in more financial stability and safety, and offer long-term growth on your money.
Now that you know the difference between asset allocation and portfolio diversification, you can go ahead and create an investment portfolio with Tata Capital Moneyfy app that is suitable for your financial goals.