- Diversification is an investment strategy that means owning a mix of investments within and across asset classes.
- The primary goal of diversification is to reduce a portfolio's exposure to risk and volatility.
- Since it aims to smooth out investments' swings, diversification minimizes losses but also limits gains.
If you're familiar with the saying, "Don't put all your eggs in one basket," you can easily understand diversification in investing.
Diversification is all about spreading out your money into different types of investments, both across and within multiple asset classes throughout your investment portfolio. Doing so can dramatically reduce risk without significantly diminishing long-term returns — and some studies even show that diversification boosts average returns.
The idea is that your investment portfolio won't be significantly affected if one particular asset (or group of assets) loses money. In other words, your eggs are in different baskets. If one falls and your eggs break, you still have other baskets of intact eggs.
"Through intelligent portfolio building and diversifying, investors can create a portfolio of risky assets with an aggregate volatility that is lower than any of the individual securities," explains Nathan Wallace, principal wealth manager at Savvy Advisors.
Many of the best robo-advisors offer instant diversification through customized and pre-built ETF portfolios. However, the diversification of ETFs might not be enough, depending on your situation. You may also want to diversify by investing in other assets outside of the stock market, like physical real estate. Consider speaking with a financial advisor to see how to best diversify based on your risk tolerance and goals.
Meanwhile, in this article, we'll examine how diversification in investing works and what it can look like.
How diversification works
Diversification works by spreading your investments across and within different asset classes to mitigate investment risk and decrease market volatility. Instead of just choosing one stock, for example, where all your risk hinges on the performance of that company, you can invest in varying stocks and other asset classes like bonds and commodities to minimize the risk of any one company or category.
"This idea is rooted in basic statistical science: While independent individual risks can be unpredictable, the frequency with which those risks tend to realize in a large population is largely predictable," notes a research paper by Paolo Sodini, a professor at the Stockholm School of Economics, and Luis M. Viceira, a professor at the Harvard Business School.
Non-correlation
Beyond the overarching idea that spreading out your investments reduces exposure to any one investment, diversification often helps because you can gain the benefit of non-correlation. That means that not all assets move in the same direction. For example, if stocks fall, sometimes bonds rise or at least don't fall as much.
So, having different types of assets can mean that your overall portfolio doesn't suffer as steep losses if one area drops, because the others might hold up better. You can enjoy less risk and less volatility along the way.
However, diversification doesn't automatically provide the benefit of non-correlation. Choosing 100 tech stocks may be less risky than just investing in one tech stock, but the 100 tech stocks are probably still correlated, so you likely want to diversify further.
Quick tip: It's important to note that the terms "risk" and "volatility" refer to two different types of measurements. The volatility of an investment alludes to the likelihood of a sudden price change. On the other hand, risk refers to the possibility that an asset will deplete in value.
Example of diversification
Suppose you put all of your money in one stock. A 10% decrease in the stock price would then mean losing 10% of your portfolio value. Yet suppose you bought 100 stocks. If one falls by 10%, yet the other 99 average out to a 0% change, then your overall portfolio would only decrease by 0.1%, not 10%. And if those other 99 stocks averaged a 1% gain, your total portfolio would increase by 0.89%, even with that one stock falling by 10%.
"The key here is to buy securities with attractive risk profiles that are not correlated to each other in a significant way with the goal that when one asset is performing poorly, another asset will pick up the slack through positive performance," says Wallace.
Types of diversification
There are different types of diversification, as assets can be categorized in various ways that affect their risk/return profiles. Not only are there overarching categories like stocks vs. bonds, but there are also ways to look at assets such as domestic vs. international.
Specifically, different types of diversification include:
Asset class diversification
Diversifying across asset classes, such as stocks, bonds, real estate, and commodities, can help mitigate risk and potentially improve returns. Owning all stocks, for example, can expose investors to high growth potential but also more volatility and potential for losses compared to bonds, which tend to be more stable yet offer lower returns. Of course, much depends on the specific assets within these asset classes, but diversification across them can help you reach your goals.
For example, if you're getting close to retirement, owning a mix of stocks and bonds can help you have some money that's focused on long-term growth (with stocks), while another bucket of money (in bonds) provides relatively consistent income that can be relied on for a given period.
Adding alternative assets or commodities like cryptocurrencies or gold might also help balance portfolios. If bond prices fall due to inflation, for example, perhaps these gain in value.
Sector diversification
In addition to diversifying across asset classes, it's important to consider diversification within asset classes. This is especially true with something like stocks, which is probably the largest, most varied of the asset classes out there.
You can parse stocks in a variety of ways. One of the most common methods is to consider them by sector. Examples of market sectors include:
- Energy
- Industrials
- Financials
- Technology
For example, it wouldn't be ideal to only invest in tech companies since they are all part of the same sector and, therefore, susceptible to the same strengths and weaknesses. Investing in stocks of other sectors could help you build a more well-rounded portfolio because they possess different characteristics and might respond differently under different economic conditions.
One way to diversify across sectors is to use index funds to own a wide variety of stocks within just one or a few vehicles. For example, an S&P 500 index fund gives exposure to 500 of the largest companies in the U.S. across sectors. Or you might buy a few sector-specific index funds to diversify.
Geographic diversification
You can further diversify your portfolio with exposure to global markets. By investing in foreign stocks and other international assets, you'll perhaps further mitigate potential losses in the event that the U.S. market takes a hit. Or perhaps stocks in other countries will simply grow at a faster rate than those in the U.S. in the coming decade or so. It's hard to predict what exactly will happen, which is why diversification can be useful.
It should be noted that investing in international stocks poses its own set of risks, including risks around currency exchanges, politics, and economics. Investors should thoroughly research a country's financial well-being, economy, and market history before allocating to other geographies.
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Benefits of diversification
There are several reasons why investors choose to diversify. Some of the main benefits typically include:
Reduced risk
Diversification tends to reduce overall portfolio risk. By holding a few dozen stocks across sectors, for example, you face less risk of an issue like an industry downturn or a corporate scandal causing you to lose a lot of money. There's still risk based on whatever assets you're investing in, e.g., holding more stocks than bonds tends to be riskier than vice versa. But diversification generally lowers the odds of losses more than a non-diversified portfolio.
Improved returns
Diversification might reduce the odds of outlandish gains, like how a single stock might gain 100% in one year, whereas a diversified portfolio is unlikely to include so many winners.
In practicality, however, diversification often leads to improved returns, because the odds of you picking those market winners are slim. Instead, what often happens is that investors choose a few stocks that end up underperforming the market average, if not losing money. But if you hold a diversified portfolio of stocks, like through an S&P 500 index fund, historically that has led to annual returns in the ballpark of 10%.
Protection against market volatility
Connected to risk and returns, diversification often reduces the impact of market volatility. For example, if you just held one stock, you might experience frequent changes in your account value. Seeing your account grow by 5% in one day might be exciting, but a 10% drop in one day might cause you to panic and sell at an inopportune time. Diversification tends to smooth out these ups and downs, though, because if one asset falters, other assets might benefit.
With geographic diversification, for example, U.S. policy changes might cause significant swings in stock prices day to day, but if you also hold some international stocks or funds, perhaps those gain value on days U.S. stocks fall, causing your overall portfolio to stay more even.
As such, you can stay calm, gain peace of mind, and potentially improve returns, such as if you're earning dividends on a higher base value rather than receiving these during periods where volatility causes your portfolio to drop.
Drawbacks of diversification
Diversification is, in many ways, a no-brainer. But there are always drawbacks to any strategy. Here are two to keep in mind:
Potential limits on returns
Diversification, by design, limits your returns to the "averages." You're betting on a lot of companies/types of investments with the goal that you'll have more winners than losers. But the clunkers will drag down the stars. So, while diversified portfolios should see fewer massive downturns than aggressive (less diversified) portfolios, they're also less likely to see extreme highs.
Time and cost
Diversification can be costly and time-consuming. Researching dozens or hundreds of stocks and bonds can take a lot of effort. Plus, buying a variety of different investments can be expensive, especially for the individual investor, due to transaction fees and taxes.
Yet that's why mutual funds and exchange-traded funds (ETFs) have become the go-to for individual investors. Buying into these baskets of securities helps you achieve instant diversification — not only within asset classes but sometimes across them. The cost is still a bit higher than individual stocks due to fund management fees, but you also typically don't have to incur as many trading costs, and the fund manager does the research for you.
How to diversify your portfolio
While the exact portfolio management strategy to take depends on your situation, some common ways to achieve diversification include:
Asset allocation
The mix of asset classes in your portfolio is known as asset allocation, such as holding 60% stocks, 30% bonds, and 10% real estate. The right asset allocation depends on your risk tolerance and investment goals.
One way to quickly diversify is to use asset allocation mutual funds or ETFs that invest in a preset mix of stocks and bonds (80/20, 70/30, or 60/40, for example) at all times and rebalance automatically. And target-date funds take things a step further by consistently adjusting toward a more conservative mix as you get closer to retirement.
Note, however, that you may need to have a more diverse asset allocation than you'd assume, as many assets are correlated with one another.
"If an investor owns both a European fund and a U.S. stock fund, they may think of themselves as diversified, but in reality, the correlation between European stocks and the US stock market has varied from about 70% to above 90% over the past decade," states Wallace. "This means that when US markets were down 10%, European markets were down between 7% and 12%. Despite the geographic diversification, investors are still exposed to risk and are not all that diversified."
So, working with a financial advisor or an online tool like a robo-advisor might help you construct an adequately diversified portfolio.
Consider costs and accessibility
Keep a close eye on your investing costs: Fund costs, trading commissions, and advisory fees can cut into your overall returns. Try to avoid costly fund transaction fees and loads (commissions), and be sure to compare fund expense ratios.
In general, index funds offer low-cost, easily accessible ways to diversify, but you still have to weigh what works best for you.
Rebalance regularly
As certain assets in your portfolio overperform (or underperform), your portfolio's weightings can move away from your target allocation. By rebalancing your portfolio once or twice a year, you'll ensure that your asset allocation is always consistent with your risk tolerance and goals.
Consider your time horizon
The length of time you're planning to invest and when you might need the funds affects your diversification approach.
For example, someone in their 20s investing for retirement might hold 100% stocks to try to maximize long-term growth, as they can withstand volatility. Still, they diversify through a mix of index funds so they're not overly exposed to a few companies. But if you're nearing retirement, your diversification might involve a mix of asset classes, leaning toward more conservative ones like bonds that provide reliable income.
The importance of portfolio diversification
Diversification is a simple concept, even if there are many ways of achieving it. Diversifying your portfolio isn't a "set it and forget it" activity. As your goals change or you age, it's likely that you'll need to tweak your asset allocation.
"There are many tools out there to track investments over time. If you have a financial advisor, your custodian will keep records of your investments and provide periodic updates to you," says Wallace.
Bear in mind that the goal of diversification generally isn't to maximize total returns but rather to limit the impact of volatility on a portfolio and improve risk-adjusted returns. In other words, diversifying can be a defensive move, but it often pays off by helping investors reach their goals more than if they were overly concentrated in one area.
Diversification and portfolio rebalancing should be part of your financial plan to help you reach your financial goals. If you need help creating or maintaining a financial plan, reach out to a financial consultant or CFP for expert guidance and advice.
FAQs about diversification
How many different investments do I need to be diversified?
There's no exact number of different investments needed to be diversified. Much depends on your goals, risk tolerance, and how you diversify. For example, some investors are comfortable owning 100% stocks but being diversified by owning a few ETFs that have exposure to hundreds of stocks. Others might own a few dozen individual stocks while also owning other assets like bonds and commodities, in accordance with their situation.
Is diversification always the best strategy?
In many cases, diversification is a best practice for investors. However, diversification isn't always the best strategy, depending on your situation, such as if you're only focused on maximizing potential profit and are willing to take the risk of highly concentrated exposures.
How often should I rebalance my portfolio?
Many experts recommend rebalancing your portfolio every six to 12 months to help make sure your asset allocation aligns with your diversification goals.
