When it comes to investing in the share market, trying to accurately predict market movements is very difficult – if not impossible. ‘Risk’ is an inevitable element of the investment decision-making.

Now, while ‘risk’ generally can’t be avoided altogether, what investors can do is try to manage it, and asset allocation and diversification are two fundamental strategies to minimise risk.

Although the two strategies are closely related and the two terms are often used in tandem, they’re also different from one another. To get you started, here’s our SHARE guide on these investment pillars.

Asset allocation at a glance

In short, asset allocation refers to the portion of shares, bonds, cash and other assets in your portfolio. As different asset classes entail a different level of (likely) risk and volatility, asset allocation allows you to balance returns and volatility intentionally in ways that meet your needs. Generally speaking, shares are typically more volatile than bonds, but with the offer of higher expected returns. And bonds tend to be more volatile than cash.

Also, asset classes move up and down independently from each other under different market conditions: at any given time, one may perform well while the other delivers poor returns. So, by investing in more than one asset class, you can counteract the losses on one side with returns on the other – and minimise the overall risk exposure of your portfolio. 

Choosing the mix of types of assets to hold is a decision that depends on a number of factors, including your investment horizon (how long before you expect to achieve your goal) and risk tolerance (your ability and willingness to withstand volatility in exchange for potential returns).

So if you have a long investment horizon ahead of you and your attitude to risk allows it, you might be able to choose a higher-risk asset allocation, with a higher proportion of shares and lower proportion of bonds and cash making up your total allocation. Over time, as you get closer to your investment goal or if your financial circumstances change, you can adjust your asset allocation to reduce the overall risk level.

What about diversification?

Similarly to asset allocation, the purpose of diversification is to spread the investment risk. But rather than referring to what percentage of your total investment is held in different asset classes, diversification is how well your investments are spread within an individual asset class as well as across the asset classes.

Here’s a practical example to clarify the concept. Suppose you’re allocating 60 per cent of your portfolio to shares and 40 per cent to bonds. That’s your asset allocation (across asset classes). Then, within the share asset class, you can choose to diversify between several assets: let’s say 20 per cent on Emerging Markets, 30 per cent on Australian shares, 25 per cent on NZ Shares and 25 per cent on International Shares. That’s the diversification bit. Diversification occurs at a more granular level too, when deciding on the individual companies or sectors to invest into.

In general, having a broad exposure to different companies, sectors and regions can be a great way to put your eggs in different ‘baskets’, rather than just one.

With all this in mind, a combination of asset allocation and diversification can help you create a well-rounded portfolio, designed to generate appropriate returns with minimised risk. Get in touch if you’d like to discuss your needs and goals.

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As always, our SHARE financial advisers are just a phone call away. We can talk through your wealth-generation options in detail – be that KiwiSaver or other investment vehicles. Click here to find an adviser near you.

Disclaimer: Please note that the content provided in this article is intended as an overview and as general information only. While care is taken to ensure accuracy and reliability, the information provided is subject to continuous change and may not reflect current developments or address your situation. Before making any decisions based on the information provided in this article, please use your discretion and seek independent guidance.