Diversification and asset allocation, explained simply

Different investments behave differently at different times. Holding several of them means a bad stretch for one does not have to derail your whole plan. This idea, diversification, is often described as the only free lunch in investing, because it can reduce risk without necessarily reducing expected return. This article explains how diversification works, how to think about your asset allocation, and how to keep it on track with rebalancing.

Why concentration is risky

If all of your money is in one company, your result depends on that company's fortunes. Losses are also harder to recover from than they appear. If an investment falls by 50%, it must then rise by 100% to get back to where you started. A portfolio with several holdings reduces the chance that one disaster has an outsized effect.

A common trap is holding too much of your employer's shares. If the company struggles, you can lose your job and a large part of your savings at the same time.

Diversify across several things

• Companies: avoid a single stock dominating your portfolio.
• Sectors: technology, healthcare, energy, financials, consumer goods and others can behave differently in different conditions.
• Regions: your home market and others, which may be affected by different economic events and currencies.
• Asset types: shares, bonds, cash and sometimes property or other assets.
• Time: investing regularly over time spreads the price you pay.

Diversification does not mean owning a long list of things that all behave the same way. Ten technology stocks are more diversified than one, but still concentrated in a single sector.

Asset allocation

Your asset allocation is the percentage of your portfolio in each asset type. It is widely seen as one of the most important decisions an investor makes, since it largely determines how much your portfolio will rise and fall.

• Shares offer higher potential growth over the long run, with larger swings.
• Bonds tend to be steadier and pay income, but grow less.
• Cash is the most stable and gives you liquidity, but may not keep up with inflation over time.

A portfolio with 60% shares and 40% bonds is a classic example of a balanced mix. A more aggressive investor might hold 80% or 90% in shares, and a more cautious one might hold a lower share.

How to choose your mix

Three things should guide the choice.

1. Your time horizon. Money you need within a few years should not be heavily exposed to the market. Money you will not need for decades can accept more risk.
2. Your ability to take risk. How secure is your income, how large is your emergency fund, and could you afford a large loss without changing your plans?
3. Your willingness to take risk. How would you feel, and what would you do, if your portfolio fell by 30%? An allocation that makes you sell in a panic is wrong for you, however good it looks on paper.

Simple rules of thumb, such as subtracting your age from 100 or 110 to get your share in equities, can be a starting point, but they are generic. Adjust for your own situation.

Rebalancing

As prices move, your mix drifts from your plan. Suppose you start with 100,000 split 60,000 in shares and 40,000 in bonds. If shares rise 20% while bonds stay flat, you hold 72,000 in shares and 40,000 in bonds, so shares are now about 64% of the portfolio. You are taking more risk than you intended.

To rebalance, you bring the mix back to 60/40: that means selling about 4,800 of shares and buying bonds with the proceeds, leaving about 67,200 in shares and 44,800 in bonds.

You can rebalance in three ways:

• On a schedule, once or twice a year.
• When it drifts, for instance when an asset class moves more than 5 percentage points from its target.
• With new money, by directing contributions to whatever is underweight, which avoids selling and any related tax or cost.

Rebalancing forces you to sell some of what has done well and buy some of what has lagged, which is the opposite of chasing performance.

Simple ways to diversify

Many investors use broad funds that hold hundreds or thousands of securities, such as a total market or global index fund, combined with a bond fund. This gives wide exposure at a low cost, without having to select individual companies. Check what a fund actually holds, since some funds that look diverse are concentrated in a few large companies.

What diversification cannot do

Diversification reduces certain risks, but it does not remove all of them, and it does not guarantee a profit or protect against loss. In a severe market downturn, many assets can fall together. It also cannot save you from owning poor investments. It is a way to manage risk, not to eliminate it.

Common mistakes

• Holding too much in one stock, sector or country.
• Mistaking the number of holdings for real diversification.
• Choosing an allocation that is too aggressive to stick with.
• Never rebalancing, so risk creeps up unnoticed.
• Over-diversifying into products you do not understand.

A short checklist

• My allocation matches my time horizon and risk tolerance.
• No single holding makes up an uncomfortably large share.
• I rebalance on a schedule or when the mix drifts.
• I understand what my funds actually hold.

Diversification does not remove risk or guarantee profit, but it lowers the chance that one mistake or one event decides your outcome.