| Definition |
The process of distributing investments across different asset classes (e.g., stocks, bonds, cash) to balance risk and reward. |
The practice of spreading investments within an asset class or across multiple securities to reduce specific risk. |
| Primary Purpose |
Manage overall portfolio risk by allocating funds to various asset categories based on goals and risk tolerance. |
Reduce unsystematic or specific risk by holding a variety of securities. |
| Focus Level |
Macro-level decision focusing on asset classes. |
Micro-level decision focusing on individual securities within or across asset classes. |
| Risk Management |
Controls exposure to market risk by balancing high-risk and low-risk asset classes. |
Mitigates company or sector-specific risks within asset classes. |
| Types of Risk Addressed |
Primarily systematic risk (market risk). |
Primarily unsystematic risk (specific risk). |
| Example |
Allocating 60% to stocks, 30% to bonds, 10% to cash. |
Holding stocks in technology, healthcare, finance, and consumer goods sectors. |
| Impact on Returns |
Aims for an optimal risk-return balance by choosing the right mix of asset classes. |
Improves risk-adjusted returns by avoiding concentration in a single security. |
| Flexibility |
Adjusted based on investor’s age, goals, risk appetite, and market conditions. |
Varies by portfolio size and availability of securities. |
| Time Horizon |
Long-term strategic planning. |
Ongoing process as portfolio evolves. |
| Investment Scope |
Across different asset classes: equities, fixed income, real estate, commodities, cash. |
Within asset classes: different stocks, bonds, sectors, or regions. |
| Examples of Asset Classes |
Stocks, bonds, cash, real estate, commodities. |
Large-cap stocks, small-cap stocks, government bonds, corporate bonds. |
| Role in Portfolio |
Foundation of portfolio construction. |
Enhances the effectiveness of asset allocation. |
| Decision Drivers |
Investor goals, risk tolerance, investment horizon. |
Portfolio size, market opportunities, risk control. |
| Performance Monitoring |
Periodic rebalancing to maintain target allocation. |
Regular review to avoid overexposure to single securities or sectors. |
| Examples of Strategies |
Strategic asset allocation, tactical asset allocation. |
Sector diversification, geographic diversification, security diversification. |
| Benefits |
Reduces portfolio volatility and aligns with investor objectives. |
Reduces risk from individual security underperformance. |
| Limitations |
Does not eliminate market risk; requires ongoing adjustment. |
Over-diversification may dilute returns. |
| Investor Examples |
Retirees shifting allocation to bonds and cash for safety. |
Investors holding multiple stocks across different sectors. |
| Summary |
Asset allocation is about choosing how much to invest in each asset class to balance risk and return. |
Diversification is about spreading investments within asset classes to reduce specific risks. |
Asset Allocation vs Diversification