Asset Allocation and Diversification

Asset allocation comes before product selection

Asset allocation is the decision about how much of a portfolio is held in broad asset classes such as shares, bonds and cash. Product selection happens after that decision. Two investors can own excellent funds and still have very different risk because one portfolio is almost entirely shares while the other has a large bond and cash allocation.

The appropriate allocation depends on the goal, how long the money can remain invested, the ability to tolerate loss, the need for liquidity and the stability of other income. Risk tolerance is psychological, but risk capacity is financial: someone may feel comfortable with volatility yet still be unable to accept a large decline if the money is needed soon.

Diversify within and across asset classes

Diversification reduces dependence on a single company, sector, region or risk factor. It can be achieved across asset classes and within each asset class. A global equity fund can diversify company exposure, but the portfolio still carries equity-market risk.

Holding several funds does not guarantee diversification if their underlying positions overlap heavily. Review top holdings, sector weights, geography and factor exposure rather than counting fund names.

Rebalancing

Market movements change portfolio weights. If shares rise faster than bonds, a portfolio that began at 60% shares may drift to 70% or more, increasing risk. Rebalancing restores the intended allocation by redirecting new contributions or buying and selling holdings.

There is no universal rebalancing frequency. Some investors use calendar intervals; others rebalance when an allocation moves beyond a chosen band. Frequent trading can create costs and tax consequences, so rebalancing should be deliberate rather than reactive.

Authoritative references

Investor.gov: asset allocation and diversification

FCA: diversification