Often, financial jargon or investment terminology can be confusing, and lacking the proper resources, hinder our ability to make successful investment decisions. Asset allocation and diversification is perhaps the most overused and least understood of all investing concepts among retail investors.
Let’s say you have $100,000 that you would like to invest in the market. The most important step in the investment process is the first step — deciding how much to have in broad asset classes such as stocks, bonds and cash. This process is called asset allocation.
Even though this sounds simple enough, investors have a hard time adhering to an asset allocation strategy because they don’t fully understand risk and return. Numerous studies have demonstrated that asset allocation — not market timing or stock selection — is the primary factor in determining why different portfolios have different return results.
Diversification is the process of determining which specific asset classes to use within the broader ones. Under the broad categories of stocks and bonds, you have specific asset classes. Just under stocks, you have U.S. stocks, international stocks, emerging market stocks, etc.
Hold on, we slice up the pie even more because within these additional asset classes, you have sub-asset classes. U.S. stocks, for example, have four distinct sub-asset classes: large cap value, large cap growth, small cap value and small cap growth. In other words, you shouldn’t just own “stocks” but also make sure you have a mix of large and small cap, growth, value and even alternative investments. This disciplined approach should be exercised across all the asset classes involved.
Just like you don’t want all your eggs in one basket, the same applies to asset classes. You reduce the risk of your portfolio by diversifying away from a single basket and into a container, Pyrex bowl, cardboard box, bucket and a bento box. Diversification can provide the potential for greater consistency and less volatility.
The key to diversification lies in understanding how the asset classes in your portfolio are related to each other, how they are correlated. If one asset class goes down while the other goes up, they are negatively correlated: for example, if U.S. large company stocks go down and Emerging Market Bonds go up. Conversely, positively correlated asset classes move together. They both go up and down in tandem. This would be true of companies in the same industry or having similar risks. Some asset classes may also be uncorrelated and move independently.
In order to determine if you have a true diversified portfolio, you must determine the correlation coefficient of all your holdings. If you work with an advisor, this is a simple software calculation you can request on your portfolio. If you participate in a 401K plan, ask the plan advisor to generate a correlation report for all the funds offered in the plan. This is an important request that you can and should make.
Andrew Brown is a Certified Financial PlannerTM and a Fee-Only Registered Investment Advisor.