Asset Allocation vs. Security Selection: What’s the Difference?

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Asset Allocation vs. Security Selection: An Overview

Asset allocation and security selection are like the highways and side roads of your investment journey, the choice of routes taking you toward your financial goals.

Allocating assets is like planning which kinds of roads to take, which can range from the Autobahns of faster growth and riskier stocks to more placid country roads that wind their way more slowly toward your destination. Just as all drivers have different tolerances for riskier speeds and strategies—some are a bit devil-may-care on the roads, others hover in the right lane, happy to be safe as others race past—you’ll need to decide what kind of journey you want this to be.

Selecting securities, meanwhile, involves following up on what kind of route you’ll take (highways, local roads, or other alternatives) with the specific choice of highways or local roads. Each will take you past different landmarks, and some might route you into the heart of a traffic jam. Security selection involves deciding which investments are best for you, especially as road conditions change, and you might have to rethink how you’ve mapped this all out.

Both are interconnected. Asset allocation provides structure and the overall route for your investment journey, ensuring you’re headed in the right direction toward your long-term financial goals. Security selection is how you’ll adapt as opportunities arise or prevailing market conditions change. To reach your financial destination, you’ll often need both. Below, we help you start mapping this out.

Key Takeaways

• Asset allocation decides which investments to include in a portfolio, while security selection picks the specific investments.
• Asset allocation tries to mix different types of investments to balance risk and maximize returns.
• Security selection is behind asset allocation and focuses on choosing individual investments like index funds, stocks, bonds, and more.
• Different kinds of trading prioritize one or the other, though most do best through how they allocate their assets.

Asset Allocation

Different types of assets react differently to market changes. For instance, when stocks thrive, bonds often don’t. Similarly, when large-cap stocks are zipping ahead, small-cap stocks tend to lag. This variation in how different asset classes respond to market conditions is called “non-correlation,” which offers some of the most positive risk protection an investor can have.

When you allocate your assets, you blend different investments to balance risk and return according to your personal goals. The aim is to create a portfolio that minimizes risk while maximizing returns.

If you’re aiming for higher returns and can handle more risk, you might have a portfolio that’s more weighted toward stocks. An 80/20 or 90/10 mix of stocks to bonds would be considered aggressive—you’ve chosen the highway’s left lane. Within your stock investments, you could include a mix of aggressive growth stocks, emerging markets, or small-cap, midcap, and large-cap stocks. Meanwhile, over in the highway’s right lane is the more conservative investor who prefers a 60/40 or 50/50 mix of stocks to bonds, with a larger portion assigned to more stable large-cap stocks.

Making Asset Allocation Decisions

Asset allocation involves finding the right mix of assets like stocks, bonds, real estate, and other investments to balance risk and potential returns. You’ll base these decisions on your financial goals and comfort with risk, aiming to get the best performance from your portfolio while minimizing risk.

Once you’ve decided on your asset mix, you’ll pick specific investments like mutual funds and exchange-traded funds (ETFs) that fit your allocation plan. This step helps you fine-tune your portfolio to better align with your goals. The important thing is to build a diverse foundation that will set you up for long-term investment success. Here’s what you need to consider:

• Risk profile: Your risk profile reflects how much risk you’re willing and able to take based on your financial psychology and financial situation. You can tailor how you allocate assets to match your risk profile, to balance the potential for returns with acceptable levels of risk.
• Timeline: Your investment timeline is crucial for deciding your asset mix. You might choose riskier investments like stocks for higher potential growth if you have a long timeline. If you need your funds soon, safer, more liquid assets like bonds are often the better choice.
• Financial goals: Your investment strategy will be shaped by your goals, whether short-term (saving for a car or home) or long-term (retirement, college funds). Asset allocation and investment selection are designed to align your choices with these goals, ensuring your portfolio is more likely to deliver what you need.

Security Selection

After determining your asset allocation strategy, it’s time to choose the securities that will make up your portfolio. Most investors start with a range of mutual funds and ETFs that align with their investment goals.

For instance, if you prefer a conservative approach, you might look for funds that emphasize protecting your capital while still offering some growth potential. Meanwhile, if you’re more aggressive in your approach, you might want to focus on growth funds.

If you’d prefer to remain a passive investor, you’ll probably lean toward low-cost index funds that track major stock indexes like the S&P 500. A conservative investor, a person who wants to preserve what they have and develop income, might consider dividend-paying stocks, while a moderate investor might combine an S&P 500 index fund with a smaller amount allocated to a midcap or small-cap fund.

Meanwhile, if you’re aiming to outperform the indexes—meaning breaking even by only buying index funds will not work—you can choose among the many actively managed funds. If you have a lot of assets or a high income, you can also work with a money manager to select individual stocks and craft a custom portfolio. Working with a financial advisor is always a prudent choice, regardless of income level.

Comparing the Importance of Asset Allocation and Security Selection

Asset allocation accepts that future asset prices are uncertain, recognizing that market and economic conditions can cause some assets to gain value while others lose. This strategy focuses more on managing risk and preparing for volatility than on managing performance. Meanwhile, selecting individual securities requires anticipating future trends. If you believe you can, then you think investors can predict price direction based on available information. While this seems common sense, it reflects a major philosophical decision about how markets work.

Those Favoring Asset Allocation

The efficient market hypothesis (EMH) states that stock prices fully reflect all available information, meaning investors can’t consistently find and exploit mispriced stocks. This means you can’t—or most can’t—beat the market. It’s not a coincidence that the EMH’s heyday was in the 1970s when index funds first gained popularity: it was thought most people would do better passively investing than trying to pick specific stocks. More broadly, if the EMH is correct, forget all those fantasies of choosing the right shares and beating the market: investors are better off selecting a suitable asset allocation and investing in a well-diversified portfolio of passively managed funds.

Modern portfolio theory (MPT), developed independently, dovetails nicely with the EMH. MPT suggests that a diversified portfolio is better than picking individual stocks or bonds and that diversifying your investments across asset types can improve your returns. The best portfolio for you will balance getting the best returns against the your level of acceptable risk.

While how you allocate your assets and choose securities are important, the first is more consequential in these theories. You should principally target the correct asset allocation, which can be done with index-tracking funds.

Those Prioritizing Security Selection

That’s not to say there aren’t advocates of active investing, including technical and fundamental analysts and active portfolio managers whose careers are based on the importance of security selection.

As a technical analyst, you would rely on price charts, trends, and patterns to forecast future price moves. You operate on the belief that studying asset price changes and their patterns can reveal investments that will outperform the market. You believe that selecting specific securities based on technical signals can be more important than simply having a broad diversity of assets.

As a fundamental analyst, you analyze companies’ financial health, market position, and competitive advantages, seeking out undervalued stocks. In-depth research into individual securities can uncover prospects for higher returns that generic asset allocation strategies overlook. Not all information is currently shared in the market—if it were, a company wouldn’t be undervalued for you to find—and you can take advantage of this inefficiency.

Now, suppose you’re an active portfolio manager, such as those in charge of hedge funds or the many mutual funds of Middle America. In that case, you emphasize active management, which aims to outperform the market by carefully selecting securities. You believe skilled managers can choose securities that exceed indexes by looking for underpriced assets or trends that broader allocation strategies would miss.

Few investors strictly adhere to either set of views. Instead, most investors are practical: they blend both strategies to suit their goals and risk tolerance. If indexes offer great returns, as they frequently have in recent decades, they will invest in them. But if they see prospects for good returns in specific assets—a stock, a real estate prospect, crypto, etc.—they’ll jump on it. Asset allocation is more meaningful for most investors in the long run. By thoughtfully combining a broad, diverse asset allocation and occasionally selecting specific securities to take advantage of investment prospects, you can benefit from the strengths of both approaches.

Example of the Security Selection for an ETF

After careful research, you invest 20% of your portfolio in technology stocks to boost potential returns while matching your risk tolerance. To do this, you could choose the Technology Select Sector SPDR Fund (XLK). This well-known ETF gives you broad exposure to the tech world, with companies specializing in hardware, software, and services.

By investing in XLK, you’ll own a piece of tech giants like Apple Inc. (AAPL), Microsoft Corporation (MSFT), Broadcom Inc. (AVGO), and Nvidia Corporation (NVDA). This approach helps you target the tech sector, in line with your overall investment strategy.

How Often Should an Investor Review Their Asset Allocation?

Investors should examine their portfolio allocation at least annually or after significant life changes to ensure it still aligns with their objectives and risk tolerance.

What Role Does an Investor’s Age Play in Asset Allocation?

This has a significant effect on asset allocation. Younger investors are often advised to take on somewhat riskier asset classes, while investors closer to retirement typically lean toward conservative, lower-risk assets.

Can Poor Security Selection Undermine a Good Asset Allocation Strategy?

Absolutely. Think of it like this: Even if you’ve perfectly balanced your portfolio with the right mix of stocks, bonds, and other assets, picking wrongly within those categories can throw everything off. Let’s say you want some tech exposure in your portfolio. Instead of a broad tech fund, you pick a few individual companies that you find promising. If those companies sink, they could drag down your entire portfolio, regardless of how well-balanced it initially was. It’s like building a house balanced on a solid foundation but then putting low-quality materials on top of it, leaving the entire structure a rickety mess.

How Does Market Volatility Affect Asset Allocation and Security Selection?

A volatile market can cause the value of different asset classes, like stocks and bonds, to shift wildly. This can throw off your original asset allocation, making your portfolio riskier and less aligned with your goals. In addition, in turbulent market conditions, strong companies with good fundamentals tend to weather the storm better than weaker ones. This shows the value of being selective about the stocks or funds you choose in periods when price swings and risks are more pronounced.

The Bottom Line

Asset allocation and security selection are essential when creating an investment strategy. By spreading your investments across different asset types based on risk and return potential, you can help minimize risk and maximize returns. While asset allocation sets the broad outline for your portfolio, security selection refines it as you choose specific investments to meet your targets. These strategies work together to form the core of a smart investment approach, with asset allocation considered a more crucial factor for most investors in their long-term success.

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