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Some think that asset allocation and diversification are the same. They ARE NOT! An investor may have excellent diversification but poor asset allocation and vice versa. To keep unnecessary risks to a minimum, you need both.
Let's start with asset allocation. This refers to the actual act of investing in different categories of investments, called asset classes. That is, we pick which assets we want to have in our portfolio. Generally, investors choose from stocks (equities), bonds (fixed income), cash, commodities and real estate.
Diversification, on the other hand, is the process of balancing these classes - and within these classes - so they offset one another amid ever-changing market conditions.
Suppose an investor buys one single stock, one bond, holds one dollar, one ounce of gold and owns a home, this is an example of excellent allocation across all the asset classes. However, the diversification is terrible.
Assume you have a total of $100 ($20 each) in the five asset classes. If the company issuing the stock goes bankrupt, you immediately lose 20% of the portfolio and now hold a total of $80. This, of course, assumes that the rest of the market does not change. The following year, the company that issued the bond defaults on its debt and cannot repay the bondholders. Now, your portfolio is worth only $60, a 40% loss in two years. The next year gold doubles, as does real estate, which brings the portfolio back to a total of $100 ($40 in gold, $40 in real estate and $20 in cash).You are back where you started financially but with fewer asset class categories. Then, stocks and bonds soar. Since you lost your stock and bond exposure when they tanked, you miss out on a huge opportunity. Not to mention that cash actually lost money (purchasing power) due to inflation. As an alternative, if you still choose the same asset classes, but diversify within those asset classes, you THEN have some protection against market volatility.
SO, don't choose just one stock, but several hundred or thousand stocks to hold - divided among small-capitalization, mid-cap, large-cap and international. Similarly, instead of one bond, hold many short-term, intermediate and long-term corporate bonds ,as well as Treasuries. The same is true for commodities (holding not only gold, but silver, etc.) and real estate.
What are EFTs? How do these work? Easy - mutual funds or exchange-traded funds allow you to put money into a mutual fund that has been invested into hundreds of securities all at once.
To keep expenses low it is recommended to choose index funds . They are a type of mutual fund that tracks the performance of an index. For the stock exposure, you can buy a total stock market index fund . There are also a total bond market index fund, a commodity index fund and a real estate investment trust (REIT) index fund. These funds not only accomplish broad asset allocation but provide excellent diversification within the assets classes. Definitely talk to your advisor before you choose any type of EFT.
