Asset allocation & diversification: a guide

Properly allocating your assets in a well-diversified way can reduce overall market risk and help meet your financial goals.

Predicting the day-to-day movements of the market can be a challenge—even for the most experienced investment professionals. Economic fundamentals are constantly in flux. Global markets are too unpredictable. And investor sentiment can turn on a dime.

So, does that mean you should avoid investing in the markets altogether? Not at all. While there is always the potential for loss, the markets have proven—over time—to be an effective source of growth. By not investing, you are simply trading one potential risk (loss of capital) for two others (inflation and longevity risk). For long-term investors, the best way to grow your assets while minimizing risk is by capitalizing on two fundamental investment strategies: asset allocation and diversification.

Asset allocation vs. diversification

While both strategies take a similar approach and are often used in tandem, asset allocation is different from diversification. Here’s a quick look at how the two strategies differ.

Asset allocation refers to the percentage (or mix) of stocks, bonds, cash and other assets in your portfolio. Since stocks are considered the most speculative of these assets, the more you hold in your portfolio, the more risk you assume.

Diversification reduces risk by distributing your assets within each of your allocation buckets. If, for example, you have 60% of your portfolio in stocks, you can give yourself more downside protection by investing in multiple sectors (consumer cyclicals, energy, financials, etc.) or regions (foreign stocks, emerging markets, etc.). The more diversified each bucket is, the less vulnerable it will be to downturns in any one category.

Does asset allocation need diversification? It depends on how risk-averse you are. While asset allocation and diversification are not necessarily interdependent, they can—when used in tandem—reduce your portfolio risk and smooth out some of the bumps during volatile markets.

The risk-reward tradeoff

While you may have to sacrifice some upside potential to reduce your portfolio risk, these strategies can help soften the blow of an underperforming market or particular asset class. Because of this, it’s important to avoid the common mistake of gauging your portfolio’s performance against the returns of the Dow Jones Industrial Average (which represents just 30 of the largest U.S. companies) or even the S&P 500®. Keep in mind that this is a trade-off—one that can be frustrating when the markets are rising but can help protect your returns when things head south.

Remember to diversify globally

When preparing a diversification strategy, it’s important to include international investment as well. Since roughly 85% of the world’s GDP is generated outside the U.S.,¹ it makes sense to pursue some of the economic growth taking place in markets around the globe. And today, given the wide range of ETFs and no-load mutual funds available, you can invest in hundreds of established and emerging global leaders with just one or two carefully chosen funds.

While asset allocation and diversification cannot guarantee a profit or protect against losses over time, a properly allocated and well-diversified portfolio is designed to provide you with competitive returns while reducing overall market risk.

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¹ “GDP based on PPP, share of world” The International Monetary Fund, April 2024 @  https://www.imf.org/external/datamapper/PPPSH@WEO/EU/CHN/USA

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