Understanding Asset Allocation & Diversification in the Financial Markets
Investing is an art that requires patience, knowledge, and dedication. Knowing when to enter and when to exit your investments is something that one learns with experience and time. However, to succeed in the financial markets, one has to learn the art of creating a well-balanced and well-diversified portfolio. You might have heard people saying “Don’t put all your eggs in one basket”. This applies perfectly to the financial markets as diversification is a great way to reduce the overall risk of your portfolio. It also ensures that your capital remains protected from black swan events and reduces the overall volatility of your portfolio. With several types of assets to invest in, diversifying your capital might seem like a challenging task.
However, asset allocation and diversification are a simple process and can help an investor protect their capital and minimize risk. With simple yet careful planning, you can achieve a well-diversified portfolio that can generate huge returns. Smart, disciplined, and well-researched investments will definitely yield high returns and help you generate wealth in the long run. However, the key to becoming a successful investor is diversification. Combining high-return investments with stable and consistent alternatives can help you create the perfect portfolio. Diversification allows investors to allocate their assets according to their risk profiles. This is an effortless way to safeguard your investments and generate wealth in the long run. In this article, we shall discuss everything from asset allocation, diversification to rebalancing your portfolio. So, let’s get started!
What is Asset Allocation?
Asset allocation is a way of investing your capital into different asset classes according to your goal, risk profile, and investment horizon. The objective of allocating your capital into different asset classes is to minimize the overall risk of your portfolio and take advantage of cross-sector investing. This ensures that your portfolio grows at a steady and consistent pace while minimizing the overall risk. Asset allocation involves separating your capital for investments in different asset classes. The three main types of asset classes are stocks, bonds, and cash or marketable securities.
Other alternative asset classes are also available such as real estate or commodities, cryptocurrencies and more. People also invest in hedge funds and start-ups as an alternative investment. When it comes to investing and asset allocation, there are a plethora of options available. However, this all depends on several factors that will decide which asset class is the best investment option for you. The main factors that affect your investment decisions and help in asset allocation are your time horizon, investment goal, and risk profile. The end goal of allocating your capital in different assets is to ensure that if one of your investments suffers a loss then the other assets can make up and balance that drawdown. It ensures no single investment can destroy your entire capital and helps in reducing your portfolio’s overall risk.
Factors to Consider
Time Horizon & Investment Goal
The first factor that you need to consider when allocating your capital is the time horizon you have planned for your investments. Your investment time horizon can range from a few weeks to months, years, and even decades. It all depends on your investing goal. For example, someone who is investing for their retirement will have a long-term horizon and will probably look for assets that offer long-term growth and will have higher risk tolerance. On the other hand, if someone is saving and investing for their child’s college education, they will have a shorter time horizon and lower risk tolerance.
Risk Tolerance & Risk Versus Reward
An investor’s risk profile is another factor that impacts their choice and selection of assets to invest in. Risk profile or risk tolerance is a person’s willingness to risk or lose a partial amount of their capital in exchange for potentially high returns. High-risk investment options come with high rewards. Similarly, low-risk and safer investment options generally tend to have lower returns. It all depends on your risk appetite and how much of your capital you are willing to lose to gain high returns.
There are two types of inventors; Aggressive investors & Conservative investors. Both have totally different risk profiles where the aggressive investor seeks high risk but high return investment opportunities. On the other hand, the conservative investor looks for safer and stable investment opportunities but at the cost of lower returns.
Available Investment Options
When it comes to investment options in the financial markets, there are a huge variety of asset classes. There are several asset classes such as stocks, mutual funds, exchange-traded funds, bonds, commodities, money market funds, cash and marketable securities, and more. The goal for any investor is to combine assets that best suit their investment goal and risk profile. Generally, the most preferred combination of assets includes investing in stocks, bonds, ETFs, mutual funds, and cash. However, it all depends on your personal preference and risk profile. Let’s go over some of the available investment options in detail –
Investing in stocks has historically given the highest returns amongst all the other asset classes, but stocks are a high-risk investment. Investing in stocks usually deliverer higher returns when compared to other asset classes like bonds, mutual funds, and cash equivalents. Investing in stocks also has additional benefits like receiving dividends. Using equity as one of the asset classes in a portfolio is a great way to diversify and balance the overall composition of the investment. However, investing in stocks brings volatility to a portfolio as many times, certain stocks turn out to be multi-baggers, but there’s a high probability that they may turn out to be dead investments with negative returns. Investing in stocks allows an investor to add high-risk but high-potential investment opportunities to their portfolio. Equity investments can be balanced by adding bonds or other safer assets that aren’t as volatile.
Bonds are usually considered as a safe and less-volatile asset class when compared to stocks. Investors might find investing in bonds to be a safer option when compared to other asset classes as they offer low but stable returns. Investing in bonds and adding them to your portfolio reduces the overall volatility and offers a stable return on investment even if the stocks in your portfolio remain volatile. While bonds generally offer low but stable returns, there are certain types of bonds that do offer high returns but are often very risky and are known as high-yield or junk bonds.
ETFs & Mutual Funds
Another asset class that investors can add to their portfolio to help attain diversification are exchange-traded funds. Along with ETFs, mutual funds can also be added to the portfolio. Generally, ETFs offer higher returns when compared to mutual funds and there are several different types of ETFs that range from sector-specific ETFs to Index funds and more. Another benefit of adding ETFs to the portfolio is that your capital will automatically be diversified as ETFs invest their capital into several different companies, shares, and market sectors. Mutual funds also are a good option to add to your portfolio, but when compared to ETFs, they tend to deliver lower returns.
Cash & Cash Equivalents
Cash and cash equivalents are another asset category that includes saving deposits, treasury bills, certificates of deposits, money market funds, and money market deposit accounts. These forms of investments offer the lowest returns but are the safest option for an investor if they do not want to take on much risk. So, if someone has a low-risk appetite, then they might consider investing in this asset class. Investing in cash and cash equivalents gives an investor the ability to invest money in the safest way at the cost of low returns.
Importance of Diversification
So, now that we have discussed some of the available asset classes, we can discuss why diversifying our investments is essential to remain in the markets for a long time and generate huge wealth while minimizing the risk on our investments. Proper asset allocation and diversification of capital ensures that your portfolio remains steady and is able to handle uncertain events and high levels of market volatility. It also allows your portfolio to remain balanced even if one asset class underperforms, as the other asset classes in the portfolio will balance the drawdown, helping in getting stable and consistent returns and growth.
Historically, the returns of all the major asset classes have never moved up and down in a similar fashion, rather they move with their own trends. This gives an investor the opportunity to diversify their capital into several different types of asset classes and ensure that the overall risk of the portfolio is reduced significantly. Asset allocation and diversification also have a major impact on whether an investor will meet their investment goal. For example, if an investor only invests in a certain stock, then their chances of reaching their investment goal and generating huge returns are very unlikely as chances are the stock that they invest in might not perform as per their expectations and even deliver negative returns. So, diversification and asset allocation play a huge role in creating a well-balanced and diversified portfolio that can create long-term wealth.
Diversification Within Individual Sectors
Another factor to consider when investing and diversifying your portfolio is to invest in different asset classes and different market sectors. So, if you decide to include stocks in your portfolio, then it is crucial that you select at least 2 or 3 different market sectors so that your portfolio attains the best possible diversification. For example, a well-balanced portfolio will include stocks from different market sectors and companies like automobile, technology, banking, and pharmaceutical. So, even if one or two market sectors underperform, the other remaining sectors will balance the drawdown and may even outperform them, helping you attain high returns.
Rebalancing & Changing Your Asset Allocation
Asset allocation and diversification of a portfolio is a task that has to be regularly monitored and rebalanced to maintain an efficient portfolio. Rebalancing your portfolio is also necessary as oftentimes, some of your investments might grow faster than others. This is crucial as over the course of time, as you reach closer to your investment goal, you might want to add more high-risk assets to your portfolio or you may even want to remove high-risk assets and completely transition to a low-risk portfolio. It all depends on how each individual asset performs and what kind of returns they offer in a given time period. Sometimes, certain assets can become dead weights, which means they do not perform at all or even start giving negative returns. So, it is crucial for an investor to remove such assets and replace them with other assets that can perform better and help you grow your wealth.
Now, we hope that you understand the importance of asset allocation and diversification as they can bring stability and security to your portfolio, helping you reach your investment goal. There are several different types of asset classes that an investor can choose from, and creating the perfect balance of assets from each class and sector gives an investor the additional benefit of being able to handle market volatility. So, go ahead and start creating the portfolio that you desire in order to achieve your investment goal and deploy your capital in the financial markets in the best way possible. We hope that this article provided you value and knowledge. If you would like to learn more about the financial markets and see more such interesting content, then do check out Jeremy’s YouTube channel “Financial Education”. Happy Investing!