Studies have found that, over the long run, how your investments are allocated is more important than individual investments, in determining overall performance for diversified portfolios.

That’s right. It’s not necessarily the specific investments you choose, but how those investments are allocated that may make the difference in reaching your financial goals.

Furthermore, the process of selecting an appropriate investment mix encourages you to organize your investments and consider your financial needs and risk tolerance, as well as external factors such as inflation, taxes, interest rates and the current economy.

Asset Allocation Versus Diversification

On the surface, asset allocation may sound very similar to diversification. Indeed, the principles are closely related; both are designed to reduce risk in your portfolio.

At its most basic, diversification means spreading money among several different investments.

By diversifying into a variety of alternatives, you can mitigate the chances of suffering a catastrophic loss should one of the investments perform poorly.

Asset allocation takes this principle one step further by diversifying your portfolio not just among different investments, but among different investment classes: stocks, fixed income alternatives such as bonds, cash equivalents, and real estate and other tangible assets.

Every investment involves some level of risk. Even CDs – traditionally considered “secure” because, unlike other investment securities, they offer a fixed rate of return – carry the risk that the rate of return received may not be enough to outpace inflation and taxes. Given that some degree of investment risk is unavoidable, your goal should be to maintain, and ultimately increase, your investment returns while managing the risks.

Asset allocation does not eliminate risk, but it can reduce your exposure to extreme highs and lows in performance. Effective asset allocation can also help preserve capital, increase liquidity and decrease portfolio volatility.

Diversification does not assure a profit or protect against loss in declining markets.