Diversification vs Asset Allocation: What's the Difference?
Diversification and asset allocation are related investment concepts, but they describe different parts of an investment approach. Both can influence risk, although neither can eliminate the possibility of investment losses.
What Is Asset Allocation?
Asset allocation refers to how an investment portfolio is distributed across different types of assets. Depending on the investor and available investments, these may include categories such as shares, bonds, cash or other asset classes.
The appropriate allocation can depend on factors including financial goals, time horizon, liquidity needs and ability to tolerate investment risk.
Asset allocation focuses on where money is distributed across broad types of investments. Diversification focuses on reducing concentration within and across those investments.
What Is Diversification?
Diversification generally means spreading investments so that a portfolio is not heavily dependent on a single company, sector, geographic area or other concentrated exposure.
Diversification may help reduce certain concentration risks, but it cannot prevent losses caused by broader market movements or other risks affecting many investments at the same time.
Key Differences
| Factor | Asset Allocation | Diversification |
|---|---|---|
| Main focus | Distribution across broad asset categories | Spreading exposure to reduce concentration |
| Example question | How much is allocated to each type of asset? | How concentrated is the portfolio? |
| Level of decision | Often portfolio-wide | Can apply within and across investments |
| Risk effect | Can influence the overall sources of portfolio risk | May reduce certain concentration risks |
How They Can Work Together
An investor might first decide how money should be distributed among broad asset categories. After that, diversification can be considered within those categories.
A portfolio may include more than one asset category. Within one category, the investor may also hold exposure to multiple companies or areas rather than relying on a single investment. This demonstrates how asset allocation and diversification can address different decisions.
Why Concentration Matters
A concentrated portfolio can be strongly affected by events involving one company, industry, country or other specific exposure. Diversification may reduce dependence on a single source of return, although it can also limit the impact of exceptional gains from a single investment.
Risk Cannot Be Eliminated
Diversification and asset allocation are risk-management concepts, not guarantees. Investment values can decline, and diversified portfolios may also experience significant losses during periods of broad market stress.
Other risks, including inflation, liquidity, interest-rate changes and economic conditions, may also affect investment outcomes.
Factors That May Influence Allocation
- Financial goals and the amount required.
- Investment time horizon.
- Ability and willingness to tolerate losses.
- Need for liquidity or access to money.
- Income, expenses and other financial obligations.
- Changes in personal circumstances.
Reviewing an Investment Approach
Over time, market movements can change the relative size of different investments within a portfolio. Personal circumstances and financial goals can also change.
Periodic review may help determine whether an investment approach continues to reflect current goals and circumstances. The appropriate frequency and actions depend on the individual situation.
Key Takeaways
- Asset allocation refers to how investments are distributed across broad asset categories.
- Diversification refers to spreading exposure to reduce certain concentration risks.
- The two concepts can work together within an overall investment approach.
- Neither diversification nor asset allocation guarantees profits or prevents losses.
- Goals, time horizon, liquidity needs and risk tolerance can influence investment decisions.