What is Portfolio Diversification?

If you’ve heard the adage, “don’t put all of your eggs in one basket,” you’re already familiar with the concept of diversification.

In short, diversification is the practice of strategically spreading your money across assets – like stocks or crypto – or different industries and categories to limit your exposure to risk, manage volatility, and maximize returns. The idea behind diversification is that if one investment or group of investments in your portfolio performs poorly, the rest may be less impacted. 

Many financial experts believe diversification is one of the best determinants of long-term investing success. Here’s why you might want to consider diversifying your portfolio, how to do it, and what to think about when using diversification as an investment strategy.

What is Diversification?

A typical diversified portfolio might hold a mix of stocks, bonds, real estate, mutual funds, cryptocurrencies, and other types of assets. This collection of assets could then be further divided into sectors such as technology, healthcare, or industrials. Additionally, the same portfolio may be distributed by geographic markets, such as domestic or international.

Different assets change in value over different time periods and behave differently in various stages of the economic and market cycle. Spreading your money across multiple types of assets may help offset declines in other parts of your portfolio and smooth out long-term investment returns. Simply put, diversification is a smart strategy because different assets may react differently to the same event – an effective way to manage risk and potentially improve investment performance over time.

Why Diversify?

Diversification doesn’t guarantee profits or insure your portfolio against losses. So, why do it?

Reducing exposure to risk is a critical part of any investment strategy. Diversification can help you accomplish that goal by keeping your portfolio from being too heavily weighted in any one asset, category, or sector. 

Let’s say you put every penny you had into the stock of a single company, and it collapsed. You’d lose all of your money. By contrast, what if you invested in a mix of stocks, bonds, cryptocurrencies, gold and commodities instead? That scenario may play out more favorably, thanks to diversification. You’d limit your overall risk of loss, and even potentially increase your returns in the long term as the other uncorrelated assets in your portfolio rose in value.

Like dollar cost averaging, which enables you to invest in consistent, planned intervals and amounts, diversification is a disciplined investing strategy. While reducing the impact of risk and volatility on your portfolio, diversification can also provide peace of mind and prevent you from making rash, knee-jerk decisions in response to sudden market declines.

Another benefit of diversification is that it can help you preserve capital, which may be important if you’re in a stage in life where significant portfolio losses could impact your ability to generate an income, such as in retirement.

The Long-Term Value of a Diversified Portfolio

If I lower my risk with diversification, doesn’t that significantly compromise the potential return? Not necessarily. For many investors, there is value in cushioning one’s portfolio from significant downturns. 

A study from Fidelity over a near 90-year time horizon evaluated concentrated and aggressive portfolios (heavily invested in stocks to achieve growth), and compared them to more conservative and diversified portfolios (allocations to bonds for income and stocks for appreciation). 

Fidelity found that the worst 12 month return for the most aggressive portfolio was -61% while the worst 12 month return was -18% for the most conservative portfolio. While the annualized return over the period for the most aggressive portfolio was 9.65% and the return for the most conservative was 5.96%, the example illustrates the danger of being overly concentrated in a single asset class.

The value of a diversified portfolio often reveals itself during drawdowns. Investors are prone to emotion, tempted to chase ever-higher returns in strong markets, and predisposed to retreat to so-called “safer” investments during periods of market turmoil. These behaviors, known as “market timing,” often result in missed opportunities and depressed portfolio performance.  A solid strategy like diversification can help you stay the course regardless of market conditions, with the potential to enjoy better investment returns over the long term.

How to Build a Diversification Strategy

There are a multitude of ways to diversify your portfolio. You can choose to diversify by asset class, such as stocks, bonds, mutual funds, cryptocurrencies, real estate, commodities, etc. Or you can also diversify within asset classes—for instance, you might decide to invest in stocks that pay dividends vs. those that don’t. You can also invest by sector, such as technology, manufacturing, industrials, and energy. And then you might drill down even further and choose a mix of individual stocks within each of those sectors. 

Since each asset is different, it will likely respond differently based on various economic and market conditions, insulating your portfolio from outsized risk. It may also provide upside potential when compared to a more concentrated positioning.

Considerations for Building a Diversified Portfolio

Before you can strategically diversify, it’s important to understand a few key elements:

  • Your appetite for risk: How much volatility are you comfortable with?

  • Your investment timeframe: Are you investing to achieve a long-term or short-term goal?

  • Your financial needs: What do you plan to use the money from your investments for? Retirement? Buying a home? Sending children to college?

Understanding your investing goals and how much risk you’re willing to take to achieve them will help inform which assets you choose to include in your portfolio. For instance, a portfolio designed to target a retirement date that’s 30 years away may be composed primarily of stocks for appreciation, whereas one dedicated to supporting an investor in retirement may be more diversified across asset classes and also more heavily weighted toward more conservative assets.

How you intend to manage your portfolio is also a factor. If you plan to do it yourself, you may spend hours researching various types of assets and stocks to create a mix of investments that meets your diversification goals. On the other hand, if you invest in a ready-made portfolio, such as an index fund or an exchange-traded fund, for example, you’ll likely have to pay management fees for that convenience. 

In addition, you’ll need to rebalance your portfolio from time to time as your goals change and as your investments gain and lose value due to normal market conditions. Although diversification is a simple investing strategy, it is be no means one-size-fits-all. What works for you may not work for another investor, and vice versa. In addition, your approach will likely change over time as your needs shift. Diversification also isn’t a one and done strategy. You’ll need to revisit and revise your portfolio as you age and as your goals evolve over time.

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