As you manage your investments, you may have heard that it's a good idea to diversify your portfolio—or have a mix of assets. The idea is to avoid putting all of your eggs in one basket.
The market fluctuates, and portfolio diversification can minimize your losses if the market drops or some of your investments perform poorly. But you also could risk losing gains if you reduce your exposure to high-performing investments. By digging a bit deeper into how diversification works, you can begin to explore how this strategy might fit into your future plan.
What is portfolio diversification?
Portfolio diversification is the practice of spreading your assets among numerous investments. It helps you to balance risk. Rather than owning just one or two securities, a diversified portfolio may contain a wide array of investments. In some cases, you might have exposure to hundreds or thousands of individual securities.
What goes into a diversified portfolio?
You can choose to invest in a mix of
- Asset allocation. The proportion of stocks versus bonds and other assets in your portfolio
- Size. Companies that are large, small and everything in between
- Sectors. Industries such as technology, transportation and consumer goods
- Regions. Companies and governments inside and outside of the United States
- Bond term. Debt instruments that last for a relatively long and short time (e.g., 30-year bonds versus short-term issues)
- Credit quality. Bond issuers that you perceive as more or less secure
What are the 4 primary components of a diversified portfolio?
You can use many different
1. Domestic stock
2. International stock
Foreign stocks often perform differently than U.S. stocks because they're issued by companies that face different laws and economic conditions in their home countries.
4. Short-term investments & cash
How many stocks should you have in a diversified portfolio?
The number of stocks you hold is less important than the number of different types of stocks you hold. Some research suggests that as few as 30 uncorrelated stocks can achieve a high degree of diversification.
Is dollar-cost averaging an effective investment strategy?
Benefits of portfolio diversification
Diversification allows you to avoid devoting your money toward just a few investments. You also gain exposure to a wider range of outcomes by spreading your money around. That can be helpful in these ways:
- You decrease the chances of being heavily invested in a security or sector that suffers a catastrophic loss.
- You increase the chances of having at least some exposure to investments that perform well.
- It can help reduce risk. It can be difficult or impossible to predict which holdings will perform best—or fall furthest—in the future. So, it's risky to invest in just one area or asset.
- Diversification also can limit volatility—the ups and downs that regularly occur in your portfolio. When you have many investments, some may gain value while others fall (or they might fall less than some of your most volatile holdings). Those different movements could offset each other or at least reduce the damage from market movements, leaving you with a more consistent return.
How to develop a diversification strategy
When you diversify, you typically invest in a variety of holdings, and you can use several strategies to accomplish that.
Determine your risk tolerance
First, determine your
Spread exposure among different types of investments
Pursue low correlation
Diversification works best when holdings behave differently. Correlation acts as a tool for measuring how investments perform relative to each other. If one investment gains in value while another investment loses value, those holdings are probably negatively correlated. Combining investments with low or negative correlations can help smooth out the ups and downs that are common in financial markets.
Consider mutual funds & ETFs
Some investment vehicles make it easy to diversify.
Monitor & rebalance your portfolio
Building a diversified portfolio is an excellent start. Over time, though, market movements could reduce your level of diversification. For example, if you have a mixture of stocks and bonds, a
Explore other types of diversification
Although diversifying your investments can help manage market risk, other strategies also can play a role. For example, ask your certified public accountant or financial advisor if it makes sense to
Likewise, strategies that involve holding some cash, investing in nontraditional asset classes such as commodities or real estate, or using annuities, also might make sense in some cases.
Example of portfolio diversification
To see how diversification works, consider a hypothetical example. You own stock A (a car manufacturer). You're considering adding stock B (another car manufacturer) or stock C (a foreign company in an unrelated industry).
Here's each stock's return in a three-year period:
|Year 1 return
|Year 2 return
|Year 3 return
You're considering splitting your money equally between stock A and either stock B or stock C. Your portfolio return for each year would be:
|If you add stock B
|If you add stock C
The returns vary each year in the portfolio that has stock A and stock B. In contrast, the annual returns stay the same in the portfolio that has stock A and stock C. That's because stock C is less correlated with stock A than stock B. This stable year-to-year return is the result of diversification.
This is a hypothetical example that represents perfect diversification using two stocks. In practice, you may want to include more than two stocks, and you may not be able to achieve perfect diversification no matter how many stocks you hold. The key takeaway is that diversification—holding assets whose returns are uncorrelated—reduces the volatility of your returns.
What's the best diversified portfolio?
There is no one-size-fits-all best diversified stock portfolio. Consider your risk tolerance, time horizon and investment goals when deciding how to invest your money. You can diversify your investments for any chosen asset allocation.
Pitfalls of portfolio diversification
Diversification is generally considered a prudent practice, but it can't guarantee profits or completely protect you from losses. Diversification helps to reduce market risk—but it doesn't eliminate it.
It isn't perfect
Consider the 2008-2009 financial crisis. Many investments lost money at least temporarily. Even a diversified portfolio likely experienced losses during that time. That includes holdings in fixed-income vehicles, which some argue are safer than stocks. Some bonds faced steep losses, with government bonds and cash among the few notable asset-class exceptions.
You don't fully participate in big wins
When you're diversified, some of your holdings may lose money or underperform at any given time. However, a long-term diversified strategy would generally have you hold on to those investments and possibly even add to them when you rebalance. That may seem counterintuitive, as you might be tempted to do the opposite—sell your losers and double down on your winners.
But picking only the winners can be risky. At some point, things could change. If you abandon diversification and switch to chasing the winners, you could risk losing the benefits of diversification at a bad time. For example, if investments that have been performing well suddenly fall, you could experience significant losses.
It comes with potential logistical issues
It's relatively easy to get a diversified portfolio with mutual funds and similar vehicles. But if every trade has transaction costs, such as commissions or markups to buy individual stocks and bonds, diversifying can get expensive. Plus, if you manage your own investments, you need to research and keep track of each holding. The more diversified you are, the more complex that becomes.
For instance, when you diversify internationally, you might take on exposure to political and currency risks that aren't present in your domestic investments. So, it's essential to evaluate your willingness and ability to learn about (and monitor) each additional asset class before you invest.
Diversification improves your chance of success
So, why is diversification of investments important? Diversification can help you manage risk, reduce volatility and build a reliable foundation for reaching your long-term financial goals. With less risk of catastrophic losses and better odds of participating in gains—wherever they might happen to materialize—your chances of success could improve.
That said, diversification can't eliminate risk, and you might even get lower returns when you diversify. That's why it's critical to build a well-designed portfolio and monitor your holdings over time. To get help with those tasks, consider partnering with a