It is hard to navigate the world of investing as a consumer. The jargon in the world of personal finance is seemingly endless. Add on the blogs, videos, and podcasts, and finally, trying to determine which resources are trustworthy - it’s no wonder employees are distracted at work. Our financial guides work daily to help employees navigate this space. A pair of terms that tend to raise questions for participants are “asset allocation” and “diversification.” After a bit of research, it might seem like these terms are the same. Our goal at Your Money Line is to help employees feel confident in knowing these terms and their implications. Once you (the investor) understand the difference between these terms (and others), you’ll feel more confident in your investing decisions. Asset allocation vs. diversification - what is the difference, really?
What is asset allocation?
Defining asset allocation requires us to work backward from the definition of the word “asset.” An asset, simply put, is something you own that has value. Your car, house, personal belongings, cash - these are all assets on a balance sheet. Asset allocation takes this definition a step further and breaks assets down into what is commonly referred to as “classes.” Assets are grouped together when they have similar characteristics. The standard asset classes are:
- Cash and cash equivalents
- Fixed income
- Real Estate
(We’ll dig a little deeper into these classes later.)
Asset allocation is the breakdown of your assets among these different classes based on your time horizon and risk tolerance. I know this is a lot of definitions so let’s break down time horizon and risk tolerance as well.
The simplest definition of the day - is time horizon. How long do you plan to hold the investment? We break down the time horizon into three groups based on when you might need the investment(s).
- Your time horizon is considered short-term if you could have use for the asset in 12 months or less, but for up to three years. As a rule, short-term investments shouldn’t be taking any risk.
- Investment goals 3-10 years away are considered “intermediate.”
- If your need for the dollars is 10+ years out, your time horizon is considered long-term.
Your risk tolerance is your ability to stomach the ups and downs of investing. If your investments decline in value, will you have trouble sleeping at night? If so, you likely have a low risk tolerance. If you handled periods of high volatility (like 2020 or the beginning of 2022) well, you have a high(er) risk tolerance.
What are the investment choices?
There are more than three asset classes, but the most common are cash, equities (stocks), and fixed income (often referred to as bonds). Your time horizon and risk tolerance will determine which classes you dabble in more than others.
Stocks (equities) are ownership in publicly traded companies. When a company wants to raise capital, it will sell part of the company to investors. You can be a part (albeit small) owner of just about any major company you can think of (McDonald's, Coca-Cola, or even Amazon).
A bond represents debt owed by the issuer. A lender (which could be a city, the federal government, or a corporation) borrows money from investors with an agreement to repay the debt. An issuer might use these funds to finance a project or even to refinance other debt. Not all bonds are created equally, and the issuer's creditworthiness will largely determine the interest rate paid.
Cash also includes cash equivalents which are dollars you can convert into cash and aren’t subject to changes in value - like money market accounts. You must keep cash on hand, or easily accessible, for emergencies.
What is asset diversification?
“Don’t put all your eggs in one basket.”
I don’t mean to belittle the complexity of this topic because you could make a career studying diversification and portfolio optimization. However, for our purposes today, the concept boils down to the egg-basket analogy. Diversification is achieved when you reduce volatility (the ups and downs of investing) by investing across different asset classes and across different companies. You can be diverse within an asset class, but diversification is truly achieved when you diversify across asset classes.
If you invest in stocks, for example, you can lower your risk by investing in several different companies of different sizes in different sectors. An investor buying McDonald’s, Yum Brands, and Chipotle would be less diversified than an investor purchasing McDonald’s, Exxon Mobil, and Tesla. Just because you’re well-diversified doesn’t mean the second investor will outperform the first. Now, if you bear with me, we’ll dive into the technicality of diversification - systematic risk.
There are two types of risk - unsystematic and systematic risk. Systematic risk always exists and cannot be eliminated by diversification, risk tolerance reduction, or any combination of strategies. Everyone who chooses to invest is exposed (to some degree) to systematic risks like interest rate risk, inflation risk, and sociopolitical risk. Unsystematic risk can be diversified away and affect different investments and asset classes differently. In our previous example, the first investor is impacted more than the second investor by the rising cost of food. However, both investors could be affected by the unsystematic risks associated with their investments, such as management, legal, and financial risk.
What’s the difference between asset allocation and diversification?
So, what is the difference between asset allocation and diversification? Glad you asked., You achieve diversification by investing both within and across asset classes. I’m sure the previous sentence is about as clear as mud so let’s break this down a bit more.
If you’re trying to diversify your investments as an investor, you’ll want to reduce your unsystematic risk and volatility. You can partially achieve this diversity by holding multiple investments in each class (think back to the second investor from our previous example). However, the most effective way to diversify your portfolio is to hold investments across classes, as they tend to have negative correlations. Depending on your risk tolerance, time horizon, and general principles, your portfolio will be most diverse by investing across asset classes and in both foreign and domestic markets.
The risk-reward tradeoff
A well-diversified portfolio could give up some short-term gain over one invested in a particular asset class. For example, if in March of 2020 you invested all of your cash in Bitcoin and then sold it about one year later, your return could have been upwards of 800% in just one year. As we can never know the true highs and lows of investments, it’s not likely you could have timed the buy and sell so perfectly (at least not on purpose). An investor who continued to hold their investment into 2022 saw almost a 50% decline in these funds. The potential reward was high, but the volatility and risk were also high.
If you want to assess your overall risk-reward relationship, consider looking at the metrics “alpha” and “beta.” Beta is a measure of risk compared to the market. Alpha measures whether, as an investor, you were rewarded for the risk taken with your investment(s).
Navigating the world of investing is not an easy task. There is a seemingly endless amount to learn even beyond the asset allocation vs diversification conversation. Your Money Line is here to help employees find the resources they need to better manage their financial lives. Though we cannot give specific investment advice, our team of Financial Guides is always here to help with the educational components of this world. Contact us for more information and a demo today, so we can help you serve your best asset, your people.