Diversification is an investing strategy used to manage risk. It involves spreading your dollars across different investments so that if one loses money, the others will hopefully make up for the loss. You can diversify your portfolio between and within asset classes.
What Is Diversification?
Diversification is an investing strategy that can help hedge against unpredictable economic conditions by selecting a variety of investments that perform differently and don’t move in lockstep with one another.
Think of diversification as the phrase “don’t put all your eggs in one basket.”
Spreading your investments across various asset classes, companies, locations and sectors can help protect your portfolio from market volatility. Over time, a diversified portfolio generally outperforms less diversified portfolios.
Managing how volatility impacts your portfolio is key to successful retirement planning. It helps ensure a smoother ride to achieve long-term growth.
When you invest in only one or two companies — or a handful of similar companies — you risk losing most of your money if there’s instability in that company or sector.
For example, imagine you only own stock in hotels and hospitality companies. If something negatively affects travel plans — much like the COVID-19 pandemic did in March 2020 — then your portfolio will experience a significant drop in value.
A diversified approach would have mixed in stocks from outside the hospitality industry, such as energy, health care and technology companies.
While the entire market crashed in March 2020, these sectors rebounded much more quickly than hotels, cruise lines and airlines.
In short: Investments that gain in value can help compensate for investments that decline.
Market downturns are often unpredictable. You can’t eliminate all investment risk from your portfolio, but diversification can help smooth the way your portfolio’s value fluctuates over time.
A portfolio should diversify in two ways: between asset classes and within asset classes.
Asset classes — especially stocks and bonds — can be divided into several subcategories: industry, growth and value, geography, and company size. Having a good mix of subcategories is essential to diversification.
If you understand your time horizon and risk tolerance, you may feel comfortable taking an active role in diversifying your portfolio and choosing your asset allocation.
Another approach is selecting mutual funds, ETFs or index funds that take the guess work out of diversification by spreading your investment dollars across several companies at once.
If you need assistance, consider consulting a financial professional who can help you determine your initial asset allocation and offer suggestions on rebalancing it over time.
An asset class is a group of investments with similar risk and return characteristics. Stocks, bonds and cash are the primary asset classes in most portfolios.
Other asset classes are less common and include real estate, commodities (natural resources and precious metals, for example) and alternative investments, such as cryptocurrency.
A mix of assets helps make your portfolio less sensitive to market swings because asset classes often react differently to market conditions.
- Mutual funds
- ETFs and index funds
- Certificates of deposit (CDs)
- Real estate
- Life insurance products
- Options and futures
Different assets — such as bonds and stocks — react differently to adverse events. In fact, they tend to move in opposite directions. When stock prices rise, for example, bond yields generally fall.
Stocks and bonds contrast in other ways. Stocks tend to be more volatile and carry a higher risk of decreased market value. However, stocks historically earn much higher returns than inflation and many other asset classes — including bonds.
Each asset class carries its unique risks and potential returns.
Before you make any investment, you should understand how the asset works and ensure the risks are appropriate.
Diversification Within Asset Classes
After choosing different types of assets, you should strive to diversify your portfolio by spreading your money across different sub-classes.
For example, stocks can be diversified by industry, geography and company size.
- Communication services
- Consumer discretionary
- Consumer staples
- Health care
- Real estate
It is also important to consider where companies are located.
Countries have varied economic cycles, so financial experts often recommend exposure to domestic and international markets. Owning stock in a few multi-national companies can help offset losses if the United States economy experiences a downturn.
The size of the companies in your stock portfolio also matters. Typically, small-cap stocks carry higher risks and higher returns than established, large-cap companies.
Bonds have their own unique characteristics to consider.
- Type of Issuer
- Several institutions issue bonds, including the U.S. government (known as Treasury bonds or T-bonds), local governments (known as municipal bonds) and corporations.
- Credit Quality
- Different bonds carry more risk than others. For example, Treasurys are considered virtually risk-free because the federal government backs them. However, they offer a low rate of return.
- A bond maturity date is when the owner receives the bond's full value — assuming there was no default. Bonds can be short-, medium- or long-term. Bonds with longer maturities, such as 30-years, carry the highest interest rate risk.
For many financial goals, investing in a blend of stocks, bonds and cash is a good way to achieve diversification.
Other Types of Diversification
Other assets such as pensions, annuities, and long-term care insurance can provide guaranteed income streams and returns.
While life insurance policies financially protect your family if you die, an annuity offers you guaranteed income in retirement through either a lump sum or installment payments.
Annuities come in many shapes and sizes, but the three most common annuity types are immediate, deferred and variable.
Annuities are complex, so make sure to research your options before adding one to your portfolio.
Building a Diversified Portfolio
The first step in building a diversified portfolio is ensuring your asset mix — stocks, bonds and other investments — aligns with your time horizon, financial goals and risk tolerance.
You should also consider how much time you can devote to monitoring and adjusting your portfolio.
Mutual Funds, ETFs and Index Funds
It can be time-consuming to research individual stocks or investigate the value of company bonds.
Mutual funds, index funds and exchange-traded funds (ETFs) are three ways you can get your portfolio diversified quickly and while reducing risk.
Each option is a collection of individual stocks or a mix of stocks and bonds. Both ETFs and mutual funds offer a variety of investments that often track indexes like the S&P 500 or specific sectors.
While there are a few key differences, ETFs, index funds and mutual funds allow you to own a small portion of many investments with a single purchase.
However, if you invest in a narrowly focused ETF or mutual fund, you need to purchase others to achieve diversification.
For example, if you purchase an ETF that tracks small-cap companies, you might also want to purchase one that tracks large-cap companies.
Robo-advisors are another way to diversify your portfolio with minimal effort. Robo-advisors are digital platforms that provide automated, algorithm-driven portfolios with little to no human supervision.
Many robo-advisor websites, such as Betterment, ask you questions about your financial goals and risk tolerance. The site uses that data to build and manage your investment portfolio automatically.
Mutual funds, ETFs and robo-advisors don’t include other asset classes, such as annuities or real estate. You may want to purchase these assets as well to attain broader diversification.
Diversifiable and Systematic Risk
While diversification can reduce risk in your portfolio, it can’t eliminate it completely.
- Systematic or market risk.
- Diversifiable or unsystematic risk.
Systematic or market risk isn’t specific to any company or industry. It can’t be eliminated or reduced through diversification.
Examples include inflation, political instability, war, weather and interest rates.
Diversifiable or unsystematic risk comes from the investments or companies themselves. Examples include the success of a company’s products and the company’s stock price.
Because these factors vary by company, diversification can reduce your exposure to unsystematic risk.
4 Cited Research Articles
- Tepper, T. (2021, May 12). The Historical Performance Of Stocks And Bonds. Retrieved from https://www.forbes.com/advisor/investing/stock-and-bond-returns/
- Chang, E. (2021, March 18). The Difference Between ETFs and Mutual Funds. Retrieved from https://money.usnews.com/investing/investing-101/articles/the-difference-between-etfs-and-mutual-funds
- Berger, R. and Curry, B. (2021, February 9). How Diversification Works, And Why You Need It. Retrieved from https://www.forbes.com/advisor/investing/what-is-diversification/
- U.S. Securities and Exchange Commission. (2009, August 28). Beginners' Guide to Asset Allocation, Diversification, and Rebalancing. Retrieved from https://www.sec.gov/reportspubs/investor-publications/investorpubsassetallocationhtm.html