What to do when ‘asset allocation,’ ‘diversification,’ and ‘correlation’ sound like nothing but gibberish
Q – I’ve been told that in my portfolio, I should allocate my investment assets to meet my risk-tolerance level, but that I should also diversify my security selections among uncorrelated investments to reduce risk. I’m absolutely lost here. Can you explain what all this means? – Asked by P.B., Toronto, Ontario
I understand your confusion. The world of financial planning and investment management is full of jargon. Unfortunately, busy planners and advisors often take it for granted that everyone is as familiar with the themes, concepts, and terminology of their industry as they are themselves. It’s a fatal mistake, because the truth of the matter is that most people who seek financial advice do so precisely because they are not experts. So to help blow away some of the fog, here’s a quick re-cap of the difference between asset allocation and investment diversification.
“Asset allocation” is the process of distributing your assets among the three basic investment groups: cash (“safety”); fixed-income (“income”); and equities (“growth”). This process is considered the most important determinant of overall portfolio success, even more so than the individual security selection within the groups. The proportion allocated to each group is guided by your personal tolerance for risk, your target portfolio return, and your time horizon. This is a highly personal decision, and your financial advisor will have a detailed questionnaire that will help you realistically define your objectives and risk tolerance. In the industry it’s called a “KYC” document, which is another industry acronym for “Know Your Client.”
If, for example, it is determined that you are a more defensive, income-oriented investor, your asset allocation might be 10% to safety, 60% to income, and 30% to growth investments. If you’re a more aggressive investor with a higher tolerance for market volatility, your asset allocation might be 5% to safety, 30% to income, and 65% to growth investments.
Asset allocation is further divided into two methods, strategic and tactical.
Strategic asset allocation involves periodically shifting assets within a portfolio so that you hold to your predefined objectives. For example, if you have set a 65% equity/35% fixed-income allocation and your equities rise to 75% as a result of a bull market, you would rebalance your portfolio back to 65% equities to remain within your target allocations.
Tactical asset allocation is an active portfolio management strategy that aims to take advantage of short-term movements in the markets. In professionally managed portfolios, the manager will allocate assets to different sectors in an attempt to capture short-term profits and then return to the portfolio’s strategic asset allocation. For example, a manager may shift a portfolio 100% to equities for a short time if they felt equity markets were undergoing a powerful rally. The risk here is that the manager makes the wrong call. That’s why the tactical asset allocation strategy is riskier than a conventional allocation strategy, and portfolios using it tend to be more volatile.
Investment diversification is the process of selecting individual investments within the broad fixed-income and equity allocations that are sufficiently uncorrelated so that they reduce the overall risk of the portfolio.
What this particular little piece of financial jargon means is that in the equity allocation of your portfolio, for example, you would spread your investment choices over a variety of industry groups and sectors, as well as over a number of different geographic regions. The theory here is that not all stocks in all sectors will always move up and down at the same time – their price movements are said to be “uncorrelated.” This has the effect of reducing overall portfolio risk, as some stocks will retreat while others rally. A properly diversified portfolio will maximize profits and minimize risk.
As a risk reduction tool, diversification makes sense. But be sure not to go crazy with diversification. If you are over-diversified, you have stretched your investment strategy too thin, and you may be doing more harm than good. Your costs may increase and your holdings may be working at cross-purposes.
Get help from someone who speaks the language
Asset allocation, investment diversification, and optimal risk are complex concepts. If you’re not terribly keen on taking up investment analysis as a second career, contact a qualified professional planner to help you set up an investment portfolio tailored to your needs. And make sure she speaks your language!
© 2015 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.