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Why is diversification of investments important?

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As you manage your investments, you may have heard that it's a good idea to diversify. Why is diversification of investments important, and what are the pros and cons of diversifying your portfolio? At its core, the idea is to avoid putting all of your eggs in one basket—because something bad could happen to that basket.

Diversification can reduce the impact of market volatility, such as market crashes, to minimize losses. However, you may sacrifice some upside when you dilute your exposure to the best-performing investments in your portfolio. By digging a bit deeper into how diversification works, you can begin to explore how this strategy might fit into your plan for the future.

What is diversification?

Diversification is the practice of spreading your assets among numerous investments. Rather than owning just one or two securities, a diversified portfolio may contain a wide array of investments. In some cases, investors have exposure to hundreds or thousands of individual securities.

You can choose to invest in a mixture of stocks and bonds to diversify, and other investment vehicles also could play a part. The more variety you have, the more diversified you are—although it's possible to go overboard.

A diversified portfolio has exposure to a variety of investments, often based on the characteristics such as:

  • 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 vs. short-term issues)
  • Credit quality. Bond issuers that you perceive as more or less secure

Benefits of 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 at least two 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 be difficult or impossible to predict which holdings will perform best—or fall furthest—in the future. Of course, you can be optimistic as a long-term investor, and you may strategize to benefit from specific trends. However, it's risky to bet everything on a narrow slice of the investment universe. Diversification helps you manage some of that risk.

Diversification also can limit volatility, or the ups and downs that regularly occur in the markets. When you have numerous investments, some may gain value while others fall (or they might fall less than some of your most volatile holdings). Those different movements have the potential to offset each other or at least dampen the damage from market movements.

How to start diversifying

When you diversify, you'll typically invest in a variety of holdings. There are several ways to accomplish that. Consider some of the strategies below as you evaluate your portfolio's diversification.

Determine risk levels

The first step in building a diversified portfolio is understanding your risk profile. Decide how much risk you're comfortable taking and evaluate your needs. With that information, you can design a portfolio that aligns with your goals.

Spread exposure among different types of investments

Decide how much to allocate to different areas and explore investing across the spectrum of characteristics listed above. Your stock and bond mixture is a good place to begin. Additionally, you might check to see if you have exposure to companies of various sizes and a variety of bond types in your portfolio. Even within sectors, it may be worth owning multiple companies, since any individual company could stumble.

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. Mutual funds and exchange-traded funds (ETFs), for example, can provide exposure to many different stocks or bonds in a single fund. Some funds have a relatively narrow objective, such as investing only in technology stocks, while others take a broader view. For instance, asset allocation funds can provide a global mixture of stocks and bonds in a single fund. However, it's crucial to understand how funds work and read a prospectus carefully before buying.

Monitor and rebalance

Building a diversified portfolio is an excellent start. Over time, though, market movements could limit your level of diversification. For example, if you have a mixture of stocks and bonds, a strong stock market may cause your stock exposure to grow larger than your original target allocation. If that happens, it could make sense to sell some of the stocks that have gained value and shift funds to areas that did not perform as well. In doing so, you are rebalancing back to your intended allocation.

Explore other types of diversification

Although diversifying your investments can help manage market risk, other strategies also can play a role in your financial plan. For example, ask your CPA or financial advisor if it makes sense to diversify your assets from a tax perspective. It could be beneficial to use various account types, such as pretax retirement accounts and Roth accounts. That way, you may be able to manage your tax liability throughout your life. While Thrivent does not provide specific legal or tax advice, we can partner with you and your tax professional or attorney.

Likewise, strategies that involve holding some cash or using annuities might also make sense in some cases.

Pitfalls of 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—it does not eliminate it.

It isn't perfect

Consider the 2008-2009 financial crisis. Many investments lost money at least temporarily. Even a diversified portfolio likely would have suffered surprising losses during that time. That includes holdings in fixed-income vehicles, which some argue are safer than stocks. Some bonds suffered steep losses, with government bonds and cash being among the few notable asset class exceptions.

You don't fully participate in big wins

When you're diversified, there's a good chance that some of your holdings are losing money or underperforming 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.

However, picking only the winners is a tall order. 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 out of favor, you could experience significant losses.

If you could predict which individual investments would outperform over specific time frames, you'd be miles ahead of professional and amateur investors. That's a feat that many strive for and few (if any) consistently achieve. You might occasionally be fortunate, and you could even get it right multiple times. But it can be risky to systematically bet your life savings on a limited set of investments. Over the long term, a disciplined and diversified approach is likely the most prudent approach.

There are potential logistical issues

It's relatively easy to get a diversified portfolio with mutual funds and similar vehicles. But if every trade comes with 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'll 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.

Bottom line

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 financial advisor who has experience designing diversified portfolios aligned with your needs.

While diversification can help reduce market risk, it does not eliminate it. Diversification does not assure a profit or protect against loss in a declining market.