What Is Diversification in Investing?
There are many important terms in the world of investing and financial planning. One of them — which can have a significant impact on your savings and future plans — is “diversification.”
Diversifying is the practice of varying your investment efforts across a number of different asset classes, in order to limit the level of risk you experience and, ideally, grow your portfolio much more successfully. It’s a valuable tool whether you’re a new investor or a seasoned trader, and can make or break your investment growth over the decades to come.
What is diversification in investing?
Investors first need to focus on their asset allocation — this is the practice of putting your money in a few different buckets, based on your current risk tolerance and your future goals. Rather than putting 100% of your portfolio in stocks and bonds, for instance, you may choose to keep a percentage in stocks with the rest spread out between bonds, cash, commodities, and real estate ventures.
Once you’ve decided on your allocation, though, it’s time to diversify your portfolio further. This means taking each bucket category (stocks and bonds, cash, etc.) and spreading those funds out amongst a variety of different, more specific “sub-buckets.”
But why is diversification so incredibly valuable when it comes to your investment portfolio?
The benefits of diversification
Imagine that you were given $100,000 to invest today, which you hope will grow over time and be the foundation of your retirement savings. You really have faith in a specific electronics brand, so you buy $100,000 in their company stock, then sit back and get ready to earn.
…except, the company files for bankruptcy in two years, catching you entirely off-guard. Your $100,000 investment not only hasn’t grown, but it’s actually worth significantly less now than when you bought the stock. You probably won’t recover your initial investment from this now-defunct company, so you’re forced to call it a loss and start your retirement portfolio journey all over again — from scratch.
If you had spread your funds out across a number of different investments, you would be in a very different position. Diversification wouldn’t have saved you from losing whatever your investment was in that specific electronics company, of course, but you would have had the remainder of your portfolio still working for you across different investments and asset class funds.
Diversification and market volatility
The primary reason diversification is so valuable is that it helps investors hedge their losses during times of market volatility.
In the example above, we put all of our eggs in one basket, sinking the entire $100,000 investment into one specific company’s stock. As with most things in life, this is often an unwise strategy.
Of course, had this hypothetical company turned into the next Amazon or Tesla, you would have been a multi-millionaire before retirement. Unfortunately, though, that’s not what happened; instead, this particular stock hit rock bottom and, because your entire portfolio was invested there, you lost nearly everything.
Stock markets are volatile, especially over time. Since most investors plan to be invested for years (if not decades), they need a way to protect themselves from those periods of volatility.
Enter diversification.
By diversifying your investment portfolio, you spread your risk out amongst a variety of industries, markets, and even specific companies. As one group of investments hits a lull, another may rise in value; a few years down the line, the exact opposite may happen.
This keeps your portfolio on a positive average trajectory, and prevents you from feeling the full impact of any market volatility that may arise throughout your investment journey.
What a diversified portfolio includes
Finances are a pretty personal matter. The things that interest you may not interest me, and the investments that I choose for my portfolio may be wildly different from the ones you’d choose for yours.
While the details are likely to vary, the overall idea of what a diversified portfolio looks like involves a few specific categories, or asset classes.
Stocks
Also known as equities, stocks will likely make up the majority of your investment portfolio. They fall into the equity asset class, and may include individual or fractional company shares, mutual fund purchases, or derivatives (what are called “futures” or “options”).
As companies grow and profit, their stock prices (or share prices) will go up. The value that you have invested in shares will also go up, according to how much stock you own. So, if you buy thirty shares in a company at $10 a piece, and 10 years from now those shares are worth closer to $300 a piece, your investment value will have gone from $300 to $9,000.
Because you’re counting on specific companies to thrive, stocks are considered a high-risk investment.
Bonds
One of the safest options for your portfolio — with a predictable, and often fixed, rate of return — is the bond.
Bonds are a type of loan taken out by an entity, funded directly by investors rather than a bank. When you purchase a bond, you’re essentially loaning a specific amount to a company or government entity in exchange for a predetermined maturity date (end) and interest rate.
Bonds represent a fixed income return. As long as you hold bonds until maturity, you should have a pretty good idea of their end yield, making them a safer option for your diversified portfolio.
They don’t have the risk of volatility that comes with stocks, but they also don’t have the opportunity for a high rate of return… so keep that in mind. In the world of investing, you can either have safe investments or you can have potential performance, depending on your risk tolerance; bonds represent the former. Bond prices are also influenced inversely by market conditions and interest rates.
You also have the option to invest in bond funds along with other investors, which are professionally managed and allow you to diversify even further.
Mutual funds
Mutual funds are prebuilt investment strategies, comprised of various stocks, bonds, and equities in specific ratios. Rather than choosing to invest in individual companies, you invest in funds which pool funds from many investors and spread that money out across the chosen investments.
As the securities within the mutual fund grow, each investor shares in the profits according to their level of investment. This investment vehicle is professionally built and managed, and can be a great way to build a diversified portfolio while also reducing market risk.
Short-term investments
Certain short-term investments can allow you to grow your money and see a return in an abbreviated period of time, with relatively low risk levels.
Short-term investments may include certificates of deposit, or CDs, which are offered by banking institutions. With CDs, you essentially lock your savings away for an agreed period of time in exchange for a specific rate of return. This is yet another fixed income strategy that is safe, but not necessarily going to make you rich.
Money market accounts, or MMAs, are interest-bearing savings accounts. Money held in a money market is considered liquid, and can be pulled from at any time. It earns interest while it’s deposited but there’s no risk of actually losing any of your money: money market accounts are another safe portfolio choice.
Then you have P2P lending and lending platforms, or various forms of angel investing. This is where investors offer to lend their own money to others, in exchange for a fixed income repayment and interest.
Lending can be more lucrative but a bit more risky. Most of the lending platforms require borrowers to have a strong history of success and/or business plan. Plus, you can usually choose whether or not a specific project sounds like a good idea.
Various funds
Then, there are various funds that you can choose to add to your portfolio, to further diversify and boost returns while limiting market risk. These include, but may not be limited to:
- Sector funds
- Real estate funds/REITs
- Commodities
- Target-date funds and asset allocation funds
- Natural resources
- Emerging markets
You don’t necessarily have to include any of these in your portfolio. Plus, in some cases — like with the target date and asset allocation funds — these may even fall into the “stocks” category of your portfolio.
Funds can be a good way to really spread your money out across a broad range of investments. These are generally built and managed by professionals, too, so they may be a great idea if you aren’t sure exactly what you need or what the market holds.
Cash
The last section of your portfolio involves liquid funds, which are available as you need them. This includes cash, your checking account balance, and any savings account balances.
Cash is important to have for emergencies, but won’t grow your portfolio (beyond your savings account interest rate, anyway).
How to diversify your portfolio
So, now that you know what goes into a diversified portfolio, in terms of different asset classes, how do you go about actually diversifying your own? Here are some of the easiest ways, especially if you’re new to investing or don’t really know where to start.
Spread out asset classes within a fund
If you don’t want to pick and choose where your money gets invested or don’t feel comfortable picking the right thing, opt for an asset allocation fund instead.
These funds are pre-set investment strategies that spread investors’ money out across a diversified portfolio according to risk tolerance. They include a defined mix of stocks, bonds, and other investments to help you (and other investors) meet your investment goals by pooling contributions together. Then, everyone shares in the returns.
Buy into funds
A mutual fund is a form of allocation funds: investment mixes designed for a pool of investors. Target date funds are a popular option, as they allow you to determine your retirement date and work backwards in terms of risk tolerance.
They are also professionally managed, though there are usually fees involved with these funds.
Revisiting your diversification strategy over time
The portfolio that works for you today may not necessarily work for you in 10 years, so you’ll want to revisit your strategy as time goes on. There are a few specific times to consider revising your approach, like
- As your portfolio shifts
- As you get older
- As your financial situation changes
- As your personal and family goals change
- As your retirement plans change
Hiring a financial advisor — or utilizing a robo-advisor platform that offers automated guidance and/or individualized personal advice — can be a great way to tell whether or not your diversification strategy is serving you well, both now and as time goes on.
Bottom line
Investing can be a great way to build wealth and help you better reach your financial goals. As with most things in life, though, it’s important not to put all of your eggs in one basket when investing, opting instead to spread your investment efforts across a variety of asset classes.
Diversifying can help you not only boost your investment efforts but also acts to hedge your savings against risk. By spreading your investments across different assets — such as mutual funds, company stocks, savings and money market accounts, CDs, and more — you can grow your portfolio while being less impacted by a market downturn or individual company failure.
And of course, be sure to adjust both your asset allocations and diversification efforts down the line. As your life, family, plans, and financial situation changes, so may your focus and goals.
