The question of how we array our investments is vital to our future financial well-being. Key to this is knowing the different between asset allocation and diversification.

Some think that asset allocation and diversification are the same. They aren’t. An investor may have excellent diversification but poor asset allocation and vice versa. To keep unnecessary risks to a minimum, we need both.

Let’s start with asset allocation. This refers to the actual act investing in different categories of investments, called asset classes. That is, we pick which assets we want to have in our portfolio. Generally, investors choose from stocks (equities), bonds (fixed income), cash, commodities and real estate.

Diversification, on the other hand, is the process of balancing these classes – and within these classes – so they offset one another amid ever-changing market conditions.

Suppose an investor buys one single stock, one bond, holds one dollar, one ounce of gold and owns a home, this is an example of excellent allocation across all the asset classes. However, the diversification is terrible.

Assume we have a total of $100 ($20 each) in the five asset classes. If the company issuing the stock goes bankrupt, we immediately lose 20% of the portfolio and now hold a total of $80. This, of course, assumes that the rest of the market does not change.

The following year, the company that issued the bond defaults on its debt and cannot repay the bondholders. Now, our portfolio is worth only $60, a 40% loss in two years. The next year gold doubles, as does real estate, which brings the portfolio back to a total of $100 ($40 in gold, $40 in real estate and $20 in cash). We are back where we started financially but with fewer asset class categories.

Then, stocks and bonds soar. Since we lost our stock and bond exposure when they tanked, we miss a huge opportunity. Not to mention that cash actually lost money (purchasing power) due to inflation.

As an alternative, if we still choose the same asset classes, but diversify within those asset classes, we have some protection against market volatility. For example, we don’t choose just one stock, but several hundred or thousand stocks to hold – divided among small-capitalization, mid-cap, large-cap and international. Similarly, instead of one bond, we hold many short-term, intermediate and long-term corporate bonds ,as well as Treasuries. The same is true for commodities (holding not only gold, but silver, etc.) and real estate.

How do we buy all this? Easy – mutual funds or exchange-traded funds. When we put money into a mutual fund or an ETF, we invest in hundreds of securities all at once.

To keep expenses low, choose index funds. They are a type of mutual fund that tracks the performance of an index. For the stock exposure, we can buy a total stock market index fund. There are also a total bond market index fund, a commodity index fund and a real estate investment trust (REIT) index fund. These funds not only accomplish broad asset allocation but provide excellent diversification within the assets classes.

This way, even if a company declared bankruptcy, and its stock and bonds become worthless, it won’t ruin our portfolio.

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Sterling Raskie, MSFS, MBA, CFP, is an independent, fee-only financial planner at Blankenship Financial Planning in New Berlin, Ill. He is an adjunct professor teaching courses in math, finance, insurance and investments. His blog is Getting Your Financial Ducks in a Row , where he writes regularly about investments, retirement savings and financial planning.

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