The ultimate use of your portfolio should shape your asset allocation.
In 4 steps to creating a portfolio, we wrote about the need for asset allocation. It really is not surprising to note that asset allocation grabs the spotlight when designing a portfolio.
Any security-specific selection decision is preceded, either implicitly or explicitly, by an asset allocation decision. Asset allocation is therefore the most fundamental of investment decisions. It establishes the framework of an investor’s portfolio and acts as a foundation on which a plan specifically identifying investments is based upon.
At this juncture, it would be wise to differentiate between asset allocation with diversification since investors tend to use the terms interchangeably. They pack their portfolio with a dozen funds and believe they have achieved both.
Differentiating between the two
Asset allocation is the process of determining the right mix of investments you should own. In other words, how much of exposure you need to have to various asset classes.
At the most fundamental level, they are equity, debt and cash. It can further be built up by looking at other asset classes such as gold, commodities, real estate, art, private equity, and collectibles.
Whatever your situation or life stage, having the right mix of investments is crucial and can increase returns and reduce risk.
On the other hand, diversification is what you invest in within these asset classes. For instance, you may decide to allocate 65% of your portfolio to equity. Figuring out how to invest your money within this asset class is where diversification comes into play. This would entail deciding on the number of equity mutual funds to hold; the mix between growth, value, infrastructure or other sector funds; how many large- and mid-cap funds; as well as whether or not to have an international fund to gain global equity exposure.
If you decide to go with just one equity fund, a 65% exposure to a single fund shows no diversification at all, despite the fact that you have planned a sensible asset allocation.
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