Asset allocation vs. diversification—what’s the difference?

What’s asset allocation?

Asset allocation describes how you spread your money across different asset classes—investment categories consisting of investments with similar characteristics. The three primary asset classes are stocks, bonds, and cash. A sample asset allocation may be investing 60% of your retirement savings in stock funds, 30% in bond funds, and 10% in cash or cash equivalents. (Cash equivalents are short-term, highly liquid investments that can be quickly converted to cash.) Think of the asset classes as different baskets—the percentage of eggs you have in each basket is your asset allocation.

Thoughtfully allocating your assets among the different classes can be helpful because each type of investment has its own risk and return potential. Mixing up the asset classes helps balance your potential long-term returns with a level of risk you’re comfortable with.

How do you choose your asset allocation for retirement?

There are several things to consider when choosing your asset allocation for your retirement savings, such as:

• How long until you plan to retire—The further away retirement is, the more time you have to endure downturns in the market. That means you may want to consider having more money in stocks, which tend to offer higher potential returns over the long term, even though they can come with greater risk in the short term. The less time you have, the more money you may want to consider allocating to cash or bonds, which generally offer more stability in exchange for lower returns.
• How you feel about risk—Do moderate changes in your retirement account balance cause you concern? If so, you may want to consider the risk potential of your investment strategy for your retirement account, which may include larger portions of cash and bonds. If you’re comfortable with short-term declines in value and want the potential for greater returns over the long term, having more money in stocks may be appropriate. This describes your risk tolerance.
• How you picture your retirement—If you want to live more comfortably in retirement, you may need to save more money, choose investments with greater return potential, or both. Alternatively, if a modest lifestyle is your preference or goal, this may be achieved with modest investment returns.

What’s diversification?

Diversifying your account builds on your asset allocation by selecting different investments within each asset class. To keep with the theme of eggs and baskets, if asset allocation is having turkey eggs in one basket, duck eggs in another, and chicken eggs in the third basket, then diversifying them is having a mix of colors and sizes in each basket.

Think about your asset allocation to stocks, for example. Your strategy might consist of investing in a single stock, but that’s not diversified. If that one company performs poorly, your entire stock allocation may suffer. But if your strategy consists of many stocks or a group of stock funds, such as mutual funds or exchange-traded funds (ETFs), your money is spread across many companies, helping balance your potential risk and return. However, it's important to remember that diversification does not guarantee a profit or eliminate the risk of a loss.

You might consider several company characteristics when choosing your investment strategy to get a balance that can work for you, such as:

• Industry
• Company size
• Geographical location
• Growth versus value equity styles

You may want to consider diversifying all your asset allocations—bonds and cash, as well—not just our stock example.

How can you diversify your retirement account?

There are a few different strategies to help diversify your retirement savings.

The do-it-yourself approach—If you want to select and manage your investments on your own, you’ll need to do your own research, choose your own diversified mix of investments, and monitor their performance. On the plus side, you’re in control, you’re able to make changes, and you can avoid any additional costs associated with working with a professional. You’re responsible for making changes over time to keep up with any changes in your asset allocation or retirement savings goals. Automatic rebalancing can help you manage your risk if your retirement plan offers it.

The do-it-yourself approach with a little help from a fund manager—You can choose a strategy of investing in target-risk or target-date funds, which are professionally managed and diversified investments. They fall in the “do-it-yourself” category, but they can make it easier to choose the investment. With target-risk funds, you choose the level of risk you’re comfortable with, and the fund manager does the asset allocation and diversification. You’re still encouraged to review your investment strategy—it’s up to you to change funds if you want to increase or decrease your investments’ risk. With target-date funds, you choose a fund based on your planned retirement date, and the fund manager shifts the asset allocation and diversification toward more conservative investments as you get closer to retirement.

The have-someone-do-it­-for-you approach—You can get help from a financial professional or take advantage of managed accounts that some plans offer. Both will identify appropriate investments based on the information you provide them. It’s your responsibility to communicate changes to your financial situation or retirement goals, but working with a financial professional or managed account can provide you with direction and guidance on how to select and manage your investments.

Why asset allocation and diversification are important

Asset allocation describes putting your money in different asset class baskets. Diversification puts a mixture of the asset class in each basket. Both strategies try to help you balance your desire for return with your need to manage your investment risk. Together, they give you a better chance of ending up with a delicious omelet, even if an egg or two cracks on the way to the kitchen.