Diversification and asset allocation
Don't put all your eggs in one basket, and choose the right mix of baskets.
Diversification
Diversification means spreading your money across many different investments so that one disaster doesn't sink you. If you own one company and it fails, you lose a lot. If you own 500 and one fails, you barely notice.
Diversification reduces the risk tied to individual companies or industries. It cannot remove market risk: when the whole market falls, a diversified portfolio usually falls too, just less dramatically than the worst single stocks. It is about avoiding wipeouts, not avoiding all losses.
Asset allocation
Asset allocation is how you split money between broad types of investments, mainly stocks, bonds and cash. It is one of the biggest drivers of how much your portfolio swings.
More stocks means more growth potential and bigger swings. More bonds and cash means a smoother ride and usually lower long-run growth. People with long time horizons often hold more stocks; people who need the money sooner often hold more bonds and cash. There is no single right mix.
Staying on track
Over time, your mix drifts as some investments grow faster. Rebalancing means occasionally moving money back to your chosen mix. Some people use target-date funds, which hold a mix of stocks and bonds and gradually become more conservative as a chosen year approaches. They are convenient, but check their fees and whether their mix suits you.
Suppose stocks fall 30% and bonds rise 2% in a year.
Portfolio A: $10,000 all in stocks becomes $7,000, a 30% loss.
Portfolio B: $6,000 stocks and $4,000 bonds. Stocks become $4,200, bonds become $4,080. Total $8,280, a 17.2% loss.
In a strong year for stocks, A would usually come out ahead. The mix decides the ride.
Key terms
- Diversification
- Spreading money across many investments to reduce the damage any one can do.
- Asset allocation
- How you divide money among stocks, bonds and cash.
- Rebalancing
- Adjusting your holdings back to your chosen mix after the market shifts it.
- Target-date fund
- A fund that mixes stocks and bonds and becomes more conservative as a target year nears.
Diversification protects you from single disasters; asset allocation sets how bumpy your ride will be.