Diversification is the process of spreading out your money in different investments, so that you’re not too exposed to any one investment. Diversification can increase your overall return without requiring you to sacrifice something in exchange, offering what economists call a “free lunch.”
Here’s how diversification works, why it’s so important and how to diversify your portfolio.
What is diversification?
Diversification means owning a variety of assets that perform differently over time, but not too much of any one investment or type. In terms of stock, a diversified portfolio would contain 20-30 (or more) different stocks across many industries. But a diversified portfolio could also contain other assets – bonds, funds, real estate, CDs and even savings accounts.
Each type of asset performs differently as an economy grows and shrinks, and each offers varying potential for gain and loss:
- Stocks offer the potential for the highest return over time, but can fluctuate wildly over shorter periods.
- Bonds can offer steadier returns with a fixed payout, but still can fluctuate, as interest rates rise and fall.
- Funds tend to be diversified because they hold many investments, but a specific fund may hold only one kind, for example, consumer goods companies. So a fund could be broadly diversified or narrowly, depending on how it’s managed.
- Real estate can appreciate slowly over time and offer the potential for income, too.
- CDs and savings accounts will not fluctuate in value but will grow steadily based on the interest rate or other contractual terms.
As some of these assets are rising rapidly, others will remain steady or fall. Over time, the frontrunners may turn into laggards, or vice versa. In other words, these assets are not highly correlated with one another, and that’s key to the appeal of diversification.
And it’s easier and cheaper than ever to ensure that your portfolio has a broad array of investments, with major brokerages slashing many of their commissions to zero.
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How diversification benefits you
Diversification has a number of benefits for you as an investor, but one of the largest is that it can actually improve your potential returns and stabilize your results. By owning multiple assets that perform differently, you reduce the overall risk of your portfolio, so that no single investment can hurt you. It’s this “free lunch” that makes diversification a truly attractive option for investors.
Because assets perform differently in different economic times, diversification smoothens your returns. While stocks are zigging, bonds are zagging, and CDs just keep steady.
In effect, by owning various amounts of each asset, you end up with a weighted average of the returns of those assets. Although you won’t achieve the startlingly high returns from owning just one rocket-ship stock, you won’t suffer its ups-and-downs either.
While diversification can reduce risk, it can’t eliminate all risk. Diversification reduces asset-specific risk – that is, the risk of owning too much of one stock (such as Microsoft) or stocks in general (relative to other investments). However, it doesn’t eliminate market risk, which is the risk of owning that type of asset at all.
For example, diversification can limit how much your portfolio falls if stocks decline, but it can’t protect you if investors decide they don’t like stocks. For assets sensitive to interest rates, such as bonds, diversification helps protect you from a problem at a specific company, but it won’t protect from the threat of rising rates generally. Even cash, or investments such as CDs and savings accounts, are threatened by inflation, although deposits are typically guaranteed up to certain limits from principal loss.
So diversification works well for asset-specific risk, but is powerless against market-specific risk.
How to diversify your portfolio
With the advent of low-cost mutual funds and ETFs, it’s actually simple to create a portfolio that’s well-diversified. Not only are these funds cheap, but major brokerages now allow you to trade many of them at no cost, too, so it’s tremendously easy to get in the game.
A basic diversified portfolio could be as simple as holding a broadly diversified index fund such as one based on the Standard & Poors 500 index, which owns stakes in hundreds of companies. But you’ll want some exposure to bonds as well to help stabilize the portfolio, and guaranteed returns in the form of CDs help, too. Finally, cash in a savings account can also give you stability as well as a source of emergency funds, if you need it.
If you want to expand beyond this basic approach, you can diversify your stock and bond holdings. For example, you might add a fund that owns companies in emerging markets or international companies more generally, because an S&P 500 doesn’t own those. Or you may opt for a fund comprised of small public companies, since that too is outside the S&P 500.
For bonds, you might choose funds that have short-term bonds and medium-term bonds, to give you exposure to both and give you a higher return in the longer-dated bonds. For CDs, you can create a CD ladder that gives you exposure to interest rates across a period of time.
Some financial advisers even suggest that clients consider adding commodities such as gold or silver to their portfolios in order to further diversify beyond traditional assets such as stocks and bonds.
Finally, however you construct your portfolio, you’re looking for assets that respond differently in different economic climates. It doesn’t create diversification if you have different funds that own all the same large stocks, because they’ll perform largely the same over time.
And if all this sounds like too much work, a fund manager or even a robo-adviser can do it all for you. A target date fund will move your assets from higher-return assets (stocks) to lower-risk (bonds) over time, as you approach some target year in the future, typically your retirement date. Similarly, a robo-adviser can structure a diversified portfolio to meet a specific goal or target date. In either case, you’re likely to pay more than if you did it yourself, however.
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Diversification offers an easy way to smoothen your returns while potentially increasing them as well. And you can have a variety of models for how diversified you want your portfolio to be, from a basic all-stock portfolio to one that holds assets across the spectrum of risk and reward.