In investing, the principals of diversification and asset allocation are frequently used synonymously but they are distinct concepts. Diversification is a broader risk management technique than asset allocation. While asset allocation is a form of diversification, there are also other ways to diversify portfolios, some of which are discussed below. For example, the volatility of a typical portfolio of stocks will decline as the number of securities in the portfolio increases due to the diversification of industry and company specific risks. Eventually, however, there is very little risk reduction benefit from the additional security as one approaches the asset class or common “risk factor.” In the academic literature, the return associated with bearing the risk common to all securities within the asset class is called a “risk premium.” Index funds, mutual funds, and exchange traded funds are designed to be easy ways for investors to access the returns associated with the most common risk premiums.
Asset allocation is a form of diversification and is the process of deciding how to divide your investment dollars across several asset class categories. Stocks, bonds, cash and real estate are the most common components of an asset allocation strategy. The general goal is to minimize volatility while maximizing return (though asset allocation alone can’t ensure a profit or eliminate the risk of a loss). The process involves dividing your investment dollars among asset categories that are not expected to respond to the same market forces in the same way at the same time. The FinTrust asset allocation process considers both long term historical risks, returns, and correlations as well as more cyclical measurements of these three critical investment inputs.
While asset allocation is the process of diversifying a portfolio between asset classes, strategy diversification is the process of diversifying a portfolio within an asset class in order to minimize volatility or capitalize on opportunities. For example, dividend paying stocks may be expected to behave differently than high growth technology stocks, and inflation linked and floating rate bonds may behave differently than fixed rate bonds, while raw land and established income properties may be expected to behave differently within real estate. The FinTrust process looks for opportunities within asset classes by monitoring and researching a wide variety of asset class strategies.
Once an asset allocation has been determined and strategies selected, one still must choose the appropriate securities as it is possible that individual securities may not follow ell designed plans made at a higher decision level. For example, one might reasonably determine that an industry will exist in the future but that a particular company within that industry may not.
The final piece in the puzzle relates to developing a cost-effective implementation because costs act as a drag on returns.
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