A well-diversified portfolio spreads your investment among different types of investments, and within different asset classes. Asset Allocation is how you accomplish this.
Asset Allocation refers to the composition of your investment portfolio. You can divide your investment in many ways, including stocks, bonds, cash, and cash equivalents. An Asset Allocation-based strategy aims to balance risks and rewards by adjusting your portfolio’s makeup based on your risk tolerance and time frame – two things that vary depending on your personal investment objectives.
Some people decide not to diversity for reasons that depend on their investment goals and time horizon. A twenty-year-old who starts investing for retirement may choose to invest solely in stocks. By contrast, a family saving for a down payment on a new home might want to have that money in cash equivalents, which are short term and highly liquid. These two Asset Allocation strategies do not spread risk across different asset classes and, hence, are not diversified.
If you are well diversified, you don’t have to try to predict what type of asset class will do well, or when it will increase in value. In other words, you don’t have to time the market. Different asset classes move independently so gains and losses in one asset class can offset gains and losses in another. That mitigates losses when the stock market turns bearish. Having a cornucopia of different assets reduces your portfolio’s overall level of risk without costing you anything extra.