Hello Readers!!
Asset Allocation and Diversification, are two different kinds of strategies executed while constructing your investment portfolio. Although these strategies are different, both help reduces and manage the risk in an individual’s investment portfolio. Somehow both these strategies are related to each other, making some investors use these terms interchangeably.
Well, let us see how are these terms related to each other.
Asset Allocation
As mentioned above, asset allocation is a kind of investment strategy that helps an investor to balance out the risk vs reward by adjusting the percentage of each asset in an investment portfolio, for these some factors are taken into consideration, like the goal the investment time frame, and the income flows.
When you plan to invest in mutual funds, the financial advisor asks you several questions and then prepares a bet asset allocation mix for his investment portfolio. Like for example for an investor who is planning to invest to create a retirement corpus, the following is the question he would be asked by a financial adviser:
• What is your age?
• When do you plan to retire?
• How much do you save?
• What does your income need later in life?
After the financial advisor gets all the answers from your side, he plans your investment in such a way that it relates to your need and what you would like to be. That generally means the risk in your portfolio is not decided by your capacity instead it is decided based on your goals, and your wealth status.
In a mutual fund investment portfolio three kinds of asset classes are included where asset allocation is defined, equity, debt, and cash.
So, for those approaching retirement, asset allocation could be 50% equities, 30% debt, and 20% cash. Or for those in the 30s, it could be 90% equities and 10% cash. Basically, there is no rule for asset allocation and is completely decided based on your goal, age, and wealth status.
Diversification!
Asset allocation help construct your portfolio by adding funds in your portfolio based on your goal, age, and health status, but it does not help you reduce the risk from your portfolio but diversifying your portfolio does!
Imagine investor ‘A’ has a single stock in his portfolio while investor ‘B’ has 20 stocks. So, in the case of ‘A’, events like earnings disappointment, product failure, or business loss (for that company) can result in his portfolio taking a huge beating. It’s called non-systematic risk in market parlance. This can be reduced by diversifying across stocks.
In contrast, ‘B’ owns 20 stocks and so any company-specific issue will not impact his portfolio as much since he has diversified across various stocks. One stock going bad would only affect 1/20th of his portfolio.
Mutual fund investors are advised that when you plan to diversify your fund, add 4-5 funds of each asset class you have in your portfolio. Within an asset class – say equity funds – you could have a mix of large-cap and midcap funds and so on. This again to some extent will depend on your age, goals, and investing capacity.
Let Us Conclude!
Asset Allocation helps you construct a portfolio enriched with different types of assets in your portfolio while diversification deals with the concentration of these assets. Basically, both these strategies are efficient for constructing an ideal investment portfolio, that will help you reduce the risk as well as increase the returns from your portfolio.
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For any kind of query you can contact us at Shri Ashutosh Securities Pvt Ltd., we are here to help you in any way possible.
Happy Investing!
(Mutual Fund investments are subject to market risk Illustrations are for example only, there is no guarantee of returns. Past performance is not an indicator/guarantee to future returns).