A common misconception is to use the terms asset allocation and diversification interchangeably. But the truth is that there is a distinct difference between the two. It's important to understand this difference, even as a beginner-investor so that you can minimize your losses and maximize your gains.

Example:

Let's look at an example of the difference between asset allocation and diversification:

There's an entrepreneur who decided that he would like to spread his potential income out between several different business ventures. He opens up a floral shop, provides floral wedding decorating services, and becomes a business consultant for small businesses. He decides that he will spend 20% of his time managing the shop, 50% of his time managing the wedding floral decorating service and 30% of his time consulting small businesses. By doing this, he has just allocated his assets.

Then, after a while, he notices that his normal inventory of flowers only sells really well during different seasons, and that he is actually losing money in the winter months. He decides to add vases and candy arrangements to his shop's inventory in order to make up for the low season. This works wonderfully. By spreading his product line out just a little bit he has just diversified his floral shop.

Asset Allocation and Diversification within investments:

There are several different classes of asset allocations. These include but are not limited to stock, bonds, money markets, and stable value funds. The most common are stocks and bonds, of course.

If you wanted to allocate your investments, you would need to decide what percentage you want put in bonds and how much you want to put into stocks. Usually, the best way to figure this percentage out is to look at your age. The closer people are to retirement, the more conservative they need to be with their money. Therefore, older people may want to go with the majority of their money sitting in bonds. The opposite is usually true for young beginner investors in their 20s and 30s.

After determining your asset allocation, you should probably look into diversification.

Diversification usually refers to stocks, which have the most depth of any investment class. Where asset allocation spreads your investment width, diversification will take you deeper into your asset allocation class.

Mutual funds are a good example of diversification. They are made up of a lot of different stocks within certain stock categories. These categories include things like Small Cap, Large Cap, Foreign, Domestic, etc....When you buy a mutual fund you are required to choose which categories you would like to be in. By doing so, you will minimize your losses and maximize your gains just like the florist.

Application:

Don't try to "beat the market"- very few people can do that. Simply allocate and diversify your investments. Every GOOD financial advisor will probably give you the same advice.

Anything to add? Anything I missed regarding this topic?