Diversifying your portfolio is one of the most important measures you can take to manage your investment risk. Diversifying your portfolio is relatively simple and it can help cushion the blow of losses when the market drops.
In this guide, we’ll explain why diversification is important, take a look at the different types of portfolio diversification, and offer tips for how to diversify your portfolio today.
What is Diversification?
Diversification is the process of spreading your investments over multiple different assets.
In effect, it involves spreading your money across a handful of different investments instead of putting all of your money in a single investment. Diversification could mean, for example, investing in a wide variety of different stocks or investing in bonds and real estate in addition to stocks.
Ideally, you will invest in assets that are not correlated. Uncorrelated assets are likely to respond differently to the same market event, whereas correlated assets are likely to respond similarly.
Why is Diversification Important?
Diversification is a simple way to reduce the overall volatility and risk of your portfolio. The best way to understand how diversification does this is with an example. Say you have $10,000 invested all in a single stock. If that company were to go bankrupt, you would lose the entirety of your portfolio. But if you were diversified such that you have $2,000 in each of 5 different companies and one went bankrupt, you would only lose 20% of your portfolio.
More generally, it’s likely in a diversified portfolio that some assets will perform well while others will perform poorly. They balance each other out to some extent, ensuring that your total portfolio value isn’t likely to take a sudden nosedive. Over the long term, as individual investments in your portfolio overperform or underperform, your portfolio as a whole is likely to match the return of the overall market.
Types of Diversification
There are several different types of diversification you can have in your portfolio. Let’s look at some of the most common categories:
Asset diversification involves investing in a mix of different asset classes, such as stocks, bonds, real estate, and precious metals. Keep in mind that cash – currency – is also its own asset class. Bonds, real estate, and precious metals are relatively uncorrelated to the stock market, so they can be useful for diversification if you are primarily invested in stocks.
Economic and market news in the US may not impact markets in Europe or Asia. So, investing in international stocks (or other international assets) is another way to diversify your portfolio.
Individual market sectors can react differently to economic events. For example, the COVID-19 pandemic virtually shut down the transportation sector while boosting the tech sector, and specifically e-commerce companies. In general, “cyclical” market sectors (for example, financial services and real estate) tend to perform better under bullish market conditions, while “defensive” sectors (for example, healthcare and utilities) tend to perform better under bearish conditions.
You can also diversify your portfolio at the level of individual stocks. If you want to invest in a single market sector, for instance, you can spread your risk out by investing in multiple companies in that sector rather than all in one company.
Easy Ways to Start Diversifying
Want to diversify your portfolio? It’s easy to get started. Here are a few of the best methods you can use:
Buy an ETF
ETFs (exchange-traded funds) invest in dozens or even hundreds of different assets. Even better, you can invest in ETFs that are specific to an asset class, geographic region, or market sector. So, if you have a lot of US stocks in your portfolio, you can invest in a bond ETF or a European stock ETF. ETFs offer a very simple and inexpensive way to diversify.
Use a Robo-advisor
Robo-advisors like Betterment and Wealthfront can build a diversified portfolio for you automatically. All you have to do is deposit the money you want to invest, and the platform will take care of investing in a diversified mix of stock and bond ETFs. Many robo-advisors let you customize your portfolio, so you have some say in how diversified you want to be.
Get Stock Picks
If you want to invest in individual stocks, you can diversify by using a stock picking service like The Motley Fool’s Stock Advisor. Stock picking services offer suggestions for stocks to invest in, and they often have diversification built-in as part of their overall risk management strategy. You can also diversify further by using two stock picking services with different approaches to the market.
Do Your Own Research
You can also create your own custom portfolio from scratch through your own research. This is the most flexible approach to diversifying since you can pick and choose ETFs and individual stocks you like. If you go this route, it’s a good idea to check that the assets you invest in are uncorrelated with one another.
Do You Need to Diversify?
Diversification is a proven strategy for mitigating investment risk and it’s widely recommended for long-term investors. That said, diversification isn’t required for everyone. There are a few things to consider when deciding how much attention to pay to diversification.
Investment Time Horizon
One of the main objectives of diversification is to smooth out ups and downs in your portfolio over time. But if you are investing money that you plan to leave invested for 20 years or more, than short-term drops in your portfolio might not matter that much. In that case, you may be okay with less diversification.
On the other hand, if you may need to pull money out of your portfolio in the near future – for example, to buy a home or to retire – then a drop in value could become problematic even if it’s only temporary.
Diversification reduces the risk of major losses in your portfolio. So, if you’re relatively risk-averse, then more diversification make sense. However, if you’re a highly risk-tolerant investor, then diversification could hold you back from potentially bigger gains. Just remember that if you bet a large portion of your portfolio on a single investment, you could also lose a lot of money.
Comfort with Stock Picking
Often, a portfolio that is not diversified consists of a just a few individual stocks. If you are comfortable with stock picking and know how to thoroughly research companies, this might be okay. However, if you’re not comfortable with stock research, then you may be better served by ETFs that give you exposure to a whole market sector.
Diversification is an easy way to protect your portfolio against major losses and reduce your overall investment risk. Diversification typically involves investing in a mix of asset classes or in stocks from different countries or market sectors. If you want to start investing today, you can get started by investing in ETFs, using a robo-advisor, trying out a stock picking service, or doing your own investment research.