Asset Allocation and Diversification Basics

Asset Allocation and Diversification Basics

Asset allocation and diversification play an important role in long-term investing. Learning the basics of each will help you understand why and better prepare you for market downturns.

How to Properly Diversify

Asset allocation is the process of dividing an investment portfolio into different assets like bonds, stocks and cash.

Diversification involves spreading out your investments in each asset category.

Think about the retailers Wal-Mart and Amazon. Both offer hundreds of thousands of different items. This opens them up to a huge customer base.

Wal-Mart primarily sells its products out of brick and mortar locations. But now that online shopping is very popular they’re focusing heavily on their online presence. Amazon offers several different services such as video streaming, cloud storage and even grocery stores.

The companies are well diversified and will profit in almost every economic condition.

Having a diverse financial portfolio keeps you in business. If one asset fails, another one should help make up for the loss.

How you choose to diversify your financial portfolio depends on your personal preference and risk tolerance. It is common for young investors to take on more risk since they are further from retirement. Taking a conservative approach helps to preserve wealth but does not build it as quickly.

“Diversification may preserve wealth, but concentration builds wealth.” – Warren Buffet

Timeframe and Risk Tolerance

It’s crucial to understand your timeframe and future financial goals. If you need the money in less than 3-5 years it’s better to stick to a high-yield savings account or bonds. If your timeframe is further out you should feel comfortable taking on more risk.

The general rule of thumb is the longer you plan to invest the more aggressive you can be. It’s easier to tolerate large drawdowns if you have many years to let your account recover.

There is no one size fits all, you’ll need to have a well thought out plan. If you are working with a large amount of capital and need assistance, then a reputable financial advisor may be in your best interest.

Common Portfolio Allocation Models

Conservative

  • Short-Term Timeframe 10+ Years. 
  • Age Usually 55+
  • Low-Risk Tolerance
  • 50% Bonds
  • 14% U.S. Stock
  • 6% Foreign Stock
  • 30% Short-Term Investments 

Moderate

  • Mid-Term Timeframe 20+ years. 
  • Age Usually 35-55
  • Medium-Risk Tolerance
  • 25% Bonds
  • 50% U.S. Stock
  • 20% Foreign Stock
  • 5% Short-Term Investments 

Aggressive

  • Long-Term Timeframe 30+ years. 
  • Age Usually 18-35
  • High-Risk Tolerance
  • 10% Bonds
  • 60% U.S. Stock
  • 25% Foreign Stock
  • 5% Short-Term Investments 

Precious metals can replace half of the short-term investments. Famous hedge fund manager Ray Dalio keeps around 5% of his portfolio in gold.

Diversifying Assets within Classes

Once you’ve determined your asset allocation it’s crucial to diversify each asset class. This is not an easy task and requires thorough research. You want your money spread throughout different sectors of the economy.

For stocks, you’ll want exposure to different industries. You’ll also need to be aware of the correlation between industries. An example could be micro-chip stocks and tech stocks.

Choose different industries that are not heavily correlated. It’s recommended to have a mix of large-, mid- and small-cap companies.

A balanced bond portfolio requires a mix of different maturities, credit ratings and interest rates. Short-term investments can consist of short-term treasuries, corporate bonds and cash.

International stocks are usually separated by emerging and developed markets. Luckily there are several ETFs that can help make the process easier.

Rebalancing

As assets go up or down in value your portfolio can become unbalanced. Stocks can outperform bonds for several years and make your holdings uneven. Once you’ve defined your target allocations you’ll need to periodically rebalance your portfolio.

How often you’ll need to rebalance again, depends on your personal preference and risk tolerance. It is common for investors to rebalance quarterly, yearly and sometimes monthly.

It is important to understand rebalancing requires you to sell. This will create a taxable event if you’re rebalancing a regular individual account.

Retirement accounts like a 401k or traditional IRA are shielded from taxes until their maturity. Make sure you understand the tax implications when deciding when to rebalance.

Diversification Helps You Weather a Recession

During the 2008-2009 recession, several different assets suffered a large decline all at the same time. However, well-diversified portfolios still held up better than all-stock portfolios.

Bonds declined but not as much as most stocks. Stocks like Wal-Mart, Comcast, and Bristol-Myers Squibb all did relatively well. Precious metals went down initially but sky-rocketed in value after the Federal Reserve implemented quantitative easing.

Bottom Line

Creating an investment plan that fits your long-term goals is essential. Trying to time the market will almost always cost you more in the long run. Choose the right balance of risk and reward that fits you best. Periodically monitor your investments and evaluate your finances.

A properly diversified portfolio should allow you to passively invest without worry. Leave speculative trading out of your retirement accounts and focus on preservation. Smaller individual trading accounts are better suited for concentration and speculative trading.