Portfolio diversification: Importance, benefits & how to start

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.

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.

You can choose to invest in a mix of stocks, bonds and other investment vehicles to diversify. The more variety you have, the more diversified you are. To help diversify your portfolio, you might consider the following characteristics and terms:

• 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

You can use many different asset classes to create a diversified portfolio, and you decide which ones you want to include. But generally, investors build diversified portfolios with at least these components:

These are stocks of large and small U.S. companies. They generally provide higher long-term returns than other investments. But they also introduce more uncertainty, as their values can fluctuate from year to year.

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.

Bonds represent loans you make to corporations and governments. They generally pay you a fixed rate of interest until maturity, and then return the principal to you. Although they may not provide the same level of growth as stocks, they're more stable.

These investments, including cash, money market accounts and certificates of deposit, can help you cover short-term expenses and reduce your portfolio's volatility.

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.

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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.

When you diversify, you typically invest in a variety of holdings, and you can use several strategies to accomplish that.

First, determine your risk profile. Decide how much risk you're comfortable taking and evaluate your needs. You then can design a portfolio that aligns with your goals.

Decide how much to allocate to different assets. Your stock and bond mixture is a good place to begin. Additionally, you might check whether your portfolio includes exposure to companies of various sizes and a variety of bond types. Even within sectors, it may be worth owning multiple companies since one company could stumble.

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.

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 the prospectus carefully before buying.

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 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 didn't perform as well. In doing so, you're rebalancing your portfolio back to your intended allocation.

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 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 doesn't provide specific legal or tax advice, we can partner with you and your tax professional or attorney.

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.

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:

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:

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.

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.

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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.

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.

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'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.

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 Thrivent financial advisor. They can help you design a diversified portfolio that aligns with your needs.