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Diversification and allocation are NOT the same thing, as I explain briefly in this post “Diversification explained simply.”
Only a few, a small number, of firms actually apply the mathematics of diversification. They pay “lip service” to the concepts using the terms diversification and allocation interchangeably, but don’t actually apply the methodology to obtain the benefits.
Diversification targets risk and return variances while allocation involves matching portfolio characteristics with what you can both tolerate (downs felt twice as much as ups behaviorally) and have the financial capacity for in relation to loss (those pesky downturns).
Certain asset classes can be combined with others to provide a “shock absorber” to those pesky downturns.
The process to optimize the mix of the same select set* of asset classes provides targeted allocations in line with your target risk profile. It is much the same as mixing sugar, water, flower, etc. differently, which results in different baked goods from those very same ingredients.
You see, focusing on each ingredient separate from the others (they all combine optimally together) leads to poor decisions about the investments (that merely fuel your plan), while more importantly, losing sight of your overall plan in the first place (because those investments continually change places (see “Can You Pick the Next Winner” graph at the bottom of this post) relative to each other year after year). Planning and investing are NOT the same thing.
Rather than random speculative results that come from undisciplined combinations of investment choices, diversification through the use of indexed funds or ETFs provide more targeted results.
*What asset class sets to choose from? Fama / French have decades of research together answering that very question. The Three-Factor and Five-Factor Models.
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