Diversification across Asset Classes

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There are many ways one can invest. You can invest in stocks and become an owner of a corporation. You can invest in bonds and make a loan to a corporation. You can invest in a portfolio of securities such as mutual funds or exchange-traded funds. Different investments may be classified by the type of investment or even the objectives of a portfolio. Because there are many different classes of assets in which to invest, it is possible to diversify your portfolio based on asset class.

By selecting investments from different asset classes, you can minimize portfolio risk and volatility in portfolio value.

Diversification across asset classes provides a cushion against market tremors. This is because each asset class has different risks, rewards, and tolerance of economic events. By selecting investments from different asset classes, you can minimize portfolio risk and volatility in portfolio value.

Investments whose price movements tend to be opposite each other are negatively correlated. For example, if a bond's price rises when certain stock prices fall, these two classes are negatively correlated. When negatively correlated assets are combined within a portfolio, the portfolio volatility is reduced. This is easy to understand: as one price goes up and the other down, the average of the two will not be as high or low as either of the asset's prices. An average is always less volatile than its components.

It is not always possible to know the precise correlation of one asset class to another. However, financial planners often recommend that you have different asset classes in your portfolio. For example, you might include cash (or equivalents), stocks or stock mutual funds, bonds or bond mutual funds, real estate, etc. It is generally accepted that such broad classes of assets help reduce portfolio volatility. If you are able to identify your investments' correlations, then you can go the next step, which is asset allocation to build an efficient portfolio.

Diversification across asset classes is another way to minimize portfolio risk. It helps improve your investment success.