What Is Diversification?
A diverse investment portfolio can help you effectively manage risk and generate stable returns. Find out how it works in this article.
Diversifying is a powerful way to protect yourself from risk and market volatility. At the most basic level, it involves having several irons in the fire by investing in various assets and securities. Then, the general idea is that even if one of your investments goes down, your overall portfolio will remain on a positive track.
In this article, we’ll illustrate how diversification works, as well as explain why it’s an important strategy. This includes a breakdown of the different tactics that can help you spread out your holdings. We’ll also explain why meeting with a financial advisor might be the most beneficial way to put together a varied portfolio and manage risk.
An Overview of Diversification
Diversification is the process of spreading out the investments in your portfolio to mitigate risk. It’s a way to avoid focusing too much on any one type of asset and putting yourself in danger of facing significant losses if that class drops in value.
Constructing a diversified portfolio that includes a range of securities better positions you to see stable returns. What this looks like can vary, but it often includes volatile investments, such as individual stocks or commodities, and more stable ones like bonds or index funds. A common rule of thumb is to pick assets that perform differently.
As an example, consider that you’ve invested in the stock market but also hold bonds and real estate properties. If one faces a down period, the idea is that your other securities will keep you afloat and help you retain a largely positive trajectory.
Ways to Diversify
While diversifying your portfolio normally consists of spreading out your holdings among various assets, this isn’t the only strategy. There are several ways to go about it, and each can be effective in certain situations. A financial advisor will often recommend one that goes along with your investment strategy and risk tolerance.
Here are some of the most common strategies:
Across Asset Class
In general, adding a wide variety of asset classes into the fold reduces your risk exposure. If you think of your portfolio as a pie chart, it becomes diverse when you have multiple categories of assets with varying percentages. Some might be more speculative, while others may be steadier.
Below is a list of classes, including a brief description of each:
- Stocks (equities). These are more volatile since they rely on the successful operation of a company or the performance of a specific sector.
- Bonds (fixed income). Because these often generate a fixed interest payment, they’re often lower risk.
- Index funds. These track a broad market index and grant you an indirect slice of sometimes hundreds of companies. They often provide stable, predictable long-term returns.
- Mutual funds. Since these typically include various types of investments, investing in one can allow you to quickly diversify.
- Exchange-traded funds (ETFs). Operating like index and mutual funds, ETFs allow you to add a variety of securities to your portfolio.
- Real estate. This can include owning actual properties or more passive options, such as REITs or crowdfunded projects.
- Certificates of deposit (CDs). These allow you to earn interest on the money you place in an account for an allotted time.
- Commodities. These include tangible items such as oil, gold, and silver.
Across Industries or Sectors
Spreading your investments across different industries is another effective way to diversify. For instance, if you’re primarily a stock market investor, you could increase the variation of your portfolio by buying shares in companies from different sectors. Investing in, say, large tech corporations, oil companies, and healthcare companies would be an example of adding differing industries to your repertoire.
A further way to minimize risk is by investing in various geographical locations. The notion behind this is that, in case an economic downturn occurs in one place, you’ve wisely allocated your funds across multiple locations. You can do this domestically (e.g., investing in both East and West Coast U.S. companies) and internationally.
A simple way to do this would be investing in an international index or mutual fund, such as the ones that track the MSCI EAFE. However, if you have more experience or are under the guidance of an advisor, you could also pick individual stocks from other nations.
Bond Issuer Type
Yet another diversification strategy is by varying the types of bond issuers. In short, bonds act as a loan that a company pays back to you with interest. There are different types of issuers, including corporate, municipal, international, convertible, and more. Though bonds are typically lower risk, if you plan on adding them to your portfolio, you can reduce the risk of losses by adding different types to your larger set of investments.
Specifically regarding the stock market, you can diversify by buying shares in companies of varying sizes. It’s not uncommon to immediately think of investing in Fortune 500 companies with vast resources and, assumedly, plenty of revenue. But just as it’s smart to purchase stakes in corporations of different sectors or geographical locations, it can also be wise to buy into both large and small companies.
Larger companies are often subject to different risk factors than their smaller counterparts. For example, in the event of an economic down period, a bigger company may have to lay off hundreds or even thousands of employees; however, a smaller, leaner company might be able to operate as usual and continue its trajectory.
Types of Accounts
Beyond spreading around investments, a final way to diversify your portfolio is by placing funds in different accounts. This can vary by person, but someone may often hold assets in a brokerage, retirement, and standard bank account. Each has a different purpose and, thus, can afford you different benefits or protections. A bank account, for example, allows for more liquidity. However, a retirement account, like an IRA or 401(k), allows you to invest and set aside money for the future.
Why It’s Smart to Diversify
When it comes to investing, the concept of not “putting all your eggs in one basket” is critical to withstand market fluctuations, operational issues, and unpredictable economic events. Diversification is important primarily because it helps you limit these risks. Taking more than one approach can often put you in a better spot to keep your portfolio’s growth on the upswing.
Building a diverse portfolio is also beneficial because it allows you to gain experience with different sectors or classes of assets. This, of course, may not be for you if you prefer a more conservative approach. But just a little variation can help you become more comfortable with different areas of investing, as well as reduce your risk of concentrating too heavily on one area.
By spreading your wealth through more than one type of asset, you could also increase your overall return potential. This is because, if you’ve diversified enough, some areas may perform well and help form a higher baseline, even if other investments aren’t performing as expected.
How a Financial Advisor Can Help
How do you know if you’ve diversified correctly or have selected the right investments? This is a difficult question to answer if you don’t have the requisite experience or aren’t comfortable with researching and picking assets to hold.
If you want to design a diverse portfolio and are unsure how to proceed, consider sitting down with a financial advisor. When you meet one, they’ll be able to use their knowledge of the industry to establish a plan that works for you. And depending on the arrangement and type of professional, they’ll work alongside you to manage and balance your portfolio over time.
When creating a diverse portfolio, you’ll want to look for professionals experienced with managing investments or creating a holistic financial plan. To find one, we recommend comparing vetted advisors. This can help you quickly select an expert that suits you and your outlook.
Frequently Asked Questions
What does it look like to diversify stocks?
Diversifying stocks can take many forms. But one common strategy is selecting stocks in companies of varying sizes, while another is selecting companies of varying sectors. Both methods work to add complementary investments to your portfolio to ensure that if something were to go awry with one, the other is still performing up to expectations and producing positive returns.
How can diversification help reduce investment risk?
The most prominent way diversification can lower investment risk is by ensuring you don’t target all your attention on one specific asset class or sector. This could lead to drastic losses if the class or industry goes through a rocky period or, in dire cases, becomes obsolete.
What is the primary distinction between asset allocation and diversification?
Though almost always mentioned together in the same breath, asset allocation and diversification have some specific differences. Diversification has more to do with investing in contrasting types of securities. On the other hand, asset allocation is the practice of ensuring that your portfolio includes a balance of various asset classes, blending risk and reward.
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