When it comes to investing in the stock market, there are few absolutes. One certainty, however, is that attempting to accurately predict the day-to-day movements of the market is doomed to fail. Global markets are too unpredictable. Economic fundamentals are constantly changing. And investor sentiment can turn on a dime.
Even during a broad-based global economic expansion, certain countries, sectors, and asset classes will significantly outperform others. One year large cap stocks might lead the way, the next year it could be high-yield bonds, and the year after that, foreign stocks. There’s no way to predict which asset classes will do best from year to year.
Of course, there is one sure way to avoid market risk: don’t invest. But that’s really just trading one potential risk for two others—inflation risk and longevity risk—that are much more likely. If you don’t invest, you have a high risk of ending up further from your goals than when you started. If you are investing for the long term, the best way to grow your assets while minimizing your risk is by using two fundamental investment strategies: asset allocation and diversification.
What’s the Difference Between Asset Allocation and Diversification?
Although the two terms are often used together, asset allocation and diversification are different but related strategies. Asset allocation refers to the percentage of your portfolio that you hold in the three allocation categories: stocks, bonds, and cash. It’s the primary determining factor in your investment risk—from a 100% stock allocation (highest risk) to a 100% cash allocation (lowest risk). Diversification is spreading your assets across the various asset classes within each of the three allocation categories to further reduce risk.
For example, an investor might have an asset allocation of 60% stock, 30% bond, and 10% cash, based on their age, goals, and risk tolerance. But if that 60% stock allocation is invested only in large cap U.S. tech stocks—without broad exposure to other sectors (such as consumer cyclicals, energy, financials, small caps) or regions (such as foreign stocks and bonds, emerging markets)—then it lacks diversification.
Regardless of the asset allocation you choose, you’ll have more predictable and less volatile returns if your portfolio is well diversified.
The Risk-Reward Tradeoff
If you reduce your overall portfolio risk by using effective asset allocation and diversification, your portfolio won’t keep pace with the returns of the best-performing asset class each year. However, it also won’t match the returns of the worst-performing asset class. Instead, it will fall somewhere in the middle, because these strategies are designed to help smooth out some of the bumps.
Because of this, it’s important to avoid the common mistake of judging your portfolio’s investment performance by comparing it to the returns of the Dow Jones Industrial Average (which represents just 30 of the largest U.S. companies) or even the S&P 500 (which comprises only large cap U.S. stocks). In fact, aside from periodic rebalancing, probably the best thing you can do is turn off the financial news and let time do its job. When the stock market is steadily rising, it may feel a bit frustrating, but when things aren’t going as well, you’ll appreciate knowing that your portfolio is well allocated and diversified.
Don’t Forget to Diversify Globally
Americans sometimes fall into the trap of investing only in U.S. assets. This isn’t the best strategy, because about 96% of the world’s population lives outside the United States, generating 75% of the world’s gross domestic product (GDP)
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. There is tremendous economic growth occurring in markets around the world, and these markets provide lots of opportunity for strong diversification. A wide range of available exchange-traded funds (ETFs) and no-load mutual funds make it easy to invest in hundreds of established and emerging global leaders with just one or two carefully chosen funds.
Asset allocation and diversification are not guaranteed to bring a profit or to protect against losses. However, a well-allocated and well-diversified portfolio is designed to bring you competitive returns over time while reducing your overall market risk.
Key Takeaways
Asset allocation
is the percentage of stocks, bonds, and cash in your portfolio.
Diversification
is spreading your assets across asset classes within the categories of stocks, bonds, and cash.
Used together, asset allocation and diversification can help reduce your overall portfolio risk
and smooth out some of the bumps during volatile markets.
Invest globally
to further diversify your portfolio and to take advantage of economic growth around the world.
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