Asset Allocation and Diversification: How are they different?

To begin with, let’s understand what asset allocation is.

I always give example of Indian thali system to explain asset allocation. We will shortly come back to this example.

Read Asset Allocation …….why and how?  to understand asset allocation in depth. 

In this article, we will understand how Asset Allocation is different from Diversification. 

Just to give you an overview of what the Asset Allocation is, here are a few lines. In Indian thali system we have different food items like chapati, sabji, daal, raita,  rice. kadhi,  chutney and sweet. Apart from different tastes it provides our body various nutrients.  Balance of all these nutrients like carbohydrates, proteins and fats are required for our body. It is never advisable to eat either only carbohydrates or only proteins. Leave aside eating only one of them, we have to maintain proper balance while consuming them. For instance, experts say that in India we consume more carbohydrates. So to balance it out, doctors suggest we have protein supplements.  

Investment instruments have different asset classes.  Asset classes can be differentiated as Equity Asset Class, Debt Asset Class, Cash Asset Class, Gold Asset Class and Real Estate Asset Class. Ideally, an Investment Portfolio is expected to be a combination of all these asset classes.  Every asset class has its own pros and cons. As, in a meal you can’t eat only Chapati for only dal, similarly in an investment portfolio you are not expected to hold only Equity Asset or only Debt Asset. It has to be a fair combination of all these. So, spreading the investment among these asset classes is known as Asset Allocation. 

Asset Allocation …….why and how?
Now, let’s move on to understand what Diversification means.

Continuing with the same example of Indian thali system –  as you have different types of rotis  and different types of rice,  in investing you can have different types of equity instruments or different types of debt instruments.

So, to get a different taste you may sometimes eat wheat roti or at times you may eat it jowar roti or at times even the ‘makke di roti’. So here, roti is an asset class and wheat roti or jowar roti or ‘makke di roti’ are different instruments within the Roti as an asset class. So, consuming different types of rotis can be looked upon as diversification within the Roti as an asset class. 

In an Equity Asset Class there can be different investment instruments such as Shares and Equity oriented Mutual Funds. Moving ahead, within Shares there can be shares of different companies. For example, shares of Maruti aur shares of Tata Motors. And at the same time there can be mutual funds of different types such as Largecap Funds or Midcap funds distributed by different mutual fund companies.

Moving ahead, lets understand the difference between Asset Allocation and Diversification

Both, Asset Allocation and Diversification are used to reduce the risk and optimise the returns. Asset Allocation plays a vital role in a Portfolio and is of supreme importance.  While, Diversification is also required, it comes after Asset Allocation. 

While Asset Allocation is required to balance the overall investment portfolio to reduce the Asset class risk, the diversification reduces Instrument risk or the risk arising out of over concentration. 

At Bonvista, we have designed a system wherein every step while designing an  investment portfolio has its weightage. These steps are –

Risk Profiling -> Goal Integration -> Asset Allocation -> Instrument Selection  ->  Diversification -> Implementation -> Periodic Review -> Results 

This approach helps in maintaining the investment objective and decluttering the investment process resulting into a investing smoother ride

Asset Class Types of Instruments within Asset Class Diversification
Debt Bank Fixed Deposit FD with SBI
FD with HDFC Bank
FD with ICICI Bank
Corporate Fixed Deposit FD with Shriram Finance
FD with Bajaj Finance
FD with HDFC
Debt Mutual Funds ICICI Prudential Ultra Short Term Fund
Kotak Credit Risk Fund
Invesco India Short Term Fund
Equity Shares Maruti
Tata Motors
Asian Paints
Equity Mutual Funds (Large Cap Fund) ICICI Prudential Bluechip Fund
Invesco India Large Cap Fund
Canara Robeco Bluechip Equity Fund
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