Investors tend to use the terms interchangeably. Often they pack their portfolio with 15-20 funds and believe have achieved both.
Asset allocation is the process of determining the right mix of investments you should own. In other words, how much of exposure you need to have to various asset classes.
At the most fundamental level, they are equity, debt and cash. It can further be built up by looking at other asset classes such as gold, commodities, real estate, art, private equity, and collectibles.
Whatever your situation or life stage, having the right mix of investments is crucial and can increase returns and reduce risk.
On the other hand, diversification is what you invest in within these asset classes. For instance, you may decide to allocate 65% of your portfolio to equity. Figuring out how to invest your money within this asset class is where diversification comes into play. This would entail deciding on the number of equity mutual funds to hold; the mix between growth, value, infrastructure or other sector funds; how many large- and mid-cap funds; as well as whether or not to have an international fund to gain global equity exposure.
If you decide to go with just one equity fund, a 65% exposure to a single fund shows no diversification at all, despite the fact that you have planned a sensible asset allocation.
Start with asset allocation
The heavy lifting of any financial plan starts well before individual investment selection. In other words, sensible portfolio construction must commence with asset allocation.
The decision regarding the mix of assets to hold in your portfolio is a very individual one. The asset allocation that works best for you at any given point in your life will depend on numerous factors such as age, time horizon for various goals, risk tolerance and risk capacity, and earning capability.
Having said that, it is easy to see how the two terms have become conflated. There could be occasions where an investor may deliberately not resort to asset allocation. For instance, when planning for retirement, a couple in their 30s may have a portfolio titled heavily towards equity and marginally towards debt. However, if the same couple was saving for the downpayment of a home 24 months down the road, they may resort to a fixed income portfolio for that goal.
Alternatively, a 24-year old woman who has just got her first job may start to save just Rs 1,500 every month for her retirement. In that case, the entire amount may go into one equity fund. So the difference between asset allocation or diversification are not relevant in this case too.
Some financial experts believe that determining your asset allocation is the most important decision that you'll make with respect to your investments - that it's even more important than the individual investments you buy.
But worth noting is that choosing an asset allocation model won't necessarily diversify your portfolio. Whether or not your portfolio is diversified will depend on how you spread the money within each asset class.
In closing, asset allocation maximises the risk-adjusted return and reduces risk by combining asset classes that have less than perfect correlations. Diversification reduces the investment specific risk. Both are necessary to maintain a healthy portfolio.
