Updated: Jan 5, 2022
In the long run, studies have found that when you are investing, it is very important to know how your investments are allocated more than individual investments, this is to determine the overall performance of a diversified portfolio. However, this is not a specific investment you should choose, but how the investment is allocated can make a difference in achieving your financial goals.
Furthermore, the process of determining the proper investment portfolio requires you to organize your investments and take into account your financial needs and risk tolerance, as well as external factors such as inflation, taxes, interest rates, and the current economy. The issue of how we organize our investments is critical to our financial stability. The key to answering this question is to understand the distinction between asset allocation and diversification. This is due to the fact that once you understand the distinctions, you will be able to approach your investment decision with strong confidence.
Asset Allocation Basics
There are various types of investments available, such as equities (stocks), fixed-income and debt (bonds), cash alternatives, and real estate. Each of these classes is different with economic conditions. For example, when stock prices rise, bond prices typically fall. As a result, when we construct our investment portfolio, we are able to resolve large fluctuations in returns by holding a mix of asset classes, normally the majority of stocks and some bonds. That is what we called asset allocation, or how much of each investment class you have in your portfolio.
By using asset allocation, you can identify the asset class that is right for you and decide what percentage of your investment ringgit you should allocate for each class. For example, you allocate 60 percent to stocks, 30 percent to bonds, 10 percent to cash alternatives.
The Four Major Classes of Assets
Traditionally, there were three major asset classes; however, today, financial advisors generally agree that there are four broad asset classes to consider when using asset allocation:
Equities: represents ownership, this is where when you purchase shares in a company you basically purchase ownership in that company. For example when the Company XYZ offers 100,000 shares and you buy 1,000, indirectly you will own 1% shares of the Company XYZ. This means you have the right to a portion of a company's profits. However, the performance is no guarantee of future returns, historically stocks have provided higher average returns than other investments. However, stocks are much more volatile than bonds or cash alternatives. Investing in stocks may be suitable for long-term investment goals.
Bonds: When you buy an institutional bond, you are basically lending money to the institution, hence it represents debt. In exchange for this loan, the institution promises to pay the loan interest in periodic installments. Bonds are less volatile than stocks because they do not offer much room for growth. However bonds, are interest-rate sensitive; for example, when interest rates rise, bond values tend to fall, and when interest rates fall, bond values tend to rise. This is because bonds offer periodic fixed interest payments at regular intervals, it may be appropriate if you want a steady income from your investments.
Cash alternatives: such as money market holdings are highly liquid investments and least volatile. Unlike stocks and other assets, cash equivalents must have a determined market price that doesn't fluctuate as they are subject to the risk of inflation, and there is the possibility of returns not exceeding rising prices. Generally, cash alternatives are suitable for short-term investments.
Real Estate: is a common type of tangible asset that people own, Commodities such as gold and livestock, also fall into this category. In general, this type of investment can survive in periods of inflation.
Diversification Basics 101
Diversification appears to be similar to asset allocation That's correct! Both principles are similar, they are intended to reduce risk in your portfolio. Diversification is the practice of dividing the money among various investments in order to reduce risk. You can reduce catastrophic losses by diversifying your alternatives if one of your investments performs poorly. Furthermore, asset allocation is critical because it has a significant impact on whether you will meet your financial objectives.
If you do not include enough risk in your portfolio, your investment may not generate a sufficient return to meet your objectives. For example, if you are saving for long-term goals such as retirement, or college, most financial experts agree that you might need to include at least some stocks or mutual fund shares in your portfolio. On the other hand, if you put too much risk in your portfolio, money for your purpose may not be there when you need it. Stock-weighted portfolios or mutual funds, for example, are not suitable for short-term purposes, such as saving for a family summer vacation.
The Relationship Between Diversification and Asset Allocation
Asset allocation does not prevent you from risk but can reduce your exposure to high and low performance. Effective asset allocation helps maintain capital, increase liquidity and reduce portfolio volatility. While diversification means having different types of investments in a particular asset class. Just like asset allocation, the purpose of diversification is to have a range of investments that will act differently in response to the economy.
Asset allocation it likes you take one step further by diversifying your portfolio not only between different investments but between different investment classes: stocks, fixed income alternatives such as bonds, cash equivalents, real estate, and other tangible assets. Every investment involves some level of risk. Even certificate deposits, traditionally considered safe, carry the risk that the rate of return received may not be enough to outpace inflation and taxes. Therefore, talk to your financial advisor and plan the strategy that best suits your risk tolerance as well as your future goals and objectives.
In short, you have to decide how to allocate and diversify your investment portfolio among these asset classes. Not only can you diversify asset classes by buying stocks, bonds, and cash alternatives, you also can diversify within a single asset class. For instance, when you invest in stocks, you can choose whether to invest in large companies that tend to be less risky rather than small companies. However, you can choose to divide your investment ringgit according to your investment style either investing for growth or value. While the investment possibilities are endless, your objective is always the same to diversify by choosing complementary investments that balance the risks and rewards in your portfolio.