It helps to reduce risk and make your portfolio more resilient, so if any single investment plummets, you'll still have others to fall back on. This article will help you understand what a diversified investment portfolio is and why it's important for whatever stage of life you're in.
We'll also give you some simple strategies for creating or rebalancing your portfolio with an eye toward diversification.
What is a diversified investment portfolio?
What is portfolio diversification in investment? A diversified portfolio is about asset allocation. A diversified portfolio should take into account:
- Your tolerance for risk
- Your investment goal(s)
- Your timeline for reaching those goals
To illustrate what a diversified portfolio looks like, think back to the food pyramid you learned about in elementary school. The food pyramid reminds us of the importance of a balanced (or diverse) diet. Different foods provide different benefits to our bodies. Too much of one group at the expense of another may lead to short- or long-term health problems.
It's the same way with investing. The diversification definition is about making conscious, purposeful decisions to divide your investment dollars among various asset classes. Failing to do so can harm your investments.
Diversify your investments beyond just dividing assets between stocks, bonds and cash. Like having varied meals instead of eating steak daily, diversifying your portfolio will help you avoid taking too much risk in one area. If the majority of a portfolio is tech stocks, for example, that's not diversification. After all, if the sector takes a downturn, it affects your whole portfolio.
To be truly diverse, strive to have a mix of different sectors within each type of investment. This way, when one sector is down, another may still perform well. For example, utility stocks are typically steady performers even during economic recessions.
There are several components (or groups) of asset classes. Each of these plays a specific role in a portfolio. For this article, we'll focus on a core portfolio that should consist of a mixture of the following investments.
Investments ranked from most aggressive to least aggressive:
- International stocks
- Domestic stocks
- Bonds
- Cash (CDs; money market funds)
There are other investment types like precious metals, real estate and currencies (including cryptocurrencies), all of which can offer great growth potential. When creating a diversified portfolio, combine assets that will likely move in opposite directions.
For example, when the economy is thriving, stocks will generally rise due to many investors wanting a higher rate of return. In contrast, when the economy falters, bonds may perform better because they are perceived as low-risk. The purpose of diversification is to ensure no matter what happens with the economy, your investments are still somewhat protected by having at least one asset class growing.
Investment diversification strategies
What is the concept of diversification in investing? Diversification is a key element of smart investing. By diversifying your portfolio, you can minimize risk and maximize returns. Several strategies to achieve diversification include allocating assets across different asset classes and regularly rebalancing.
Asset classes
The first step in building a diversified portfolio is understanding the different investment types. The main asset classes are stocks, bonds, short-term investments, international stocks and other investments such as real estate or commodities.
Stocks represent an ownership stake in a company. When the company does well financially, stock prices usually rise. Bonds are debt instruments companies or governments use to finance their operations or pay for capital projects. Returns on bonds are usually fixed over a specific period. Short-term investments include certificates of deposits (CDs) and money market accounts that offer low risk and low returns over a short period (usually one year or less). Meanwhile, international stocks give you exposure to foreign markets with potentially higher returns than domestic ones.
Other investment classes you may want to consider include real estate, commodities such as gold or oil, private equity, venture capital funds, hedge funds and cryptocurrencies like Bitcoin or Ethereum. These other investments come with a much higher level of risk than traditional stocks and bonds because they don't have the same government regulation or stability.
Once you know which asset classes you want to invest in, establish how much money should go into each category (this could be done based on percentage breakdowns). Rebalancing helps keep your portfolio within those target allocations so no single sector gets too big, which could be damaging if it performs poorly in an economic downturn. Within these asset classes, there are other factors to consider to help diversify your portfolio, such as:
Industries/sectors
Different industries or sectors have different levels of risk and potential returns. Look at one sector at a time when researching diversifying investments since stocks within each sector tend to behave similarly when economic conditions change. For example, stocks in the technology sector tend to rise sharply when there's a new, exciting technological advancement, while stocks in the energy sector may fall if oil prices go down.
Markets
There are two main types of markets: domestic (or United States) and international. Domestic markets typically consist of stocks traded on major U.S. exchanges such as the New York Stock Exchange (NYSE) or the Nasdaq Composite Index. This type of investment exposes you to publicly traded companies based in the U.S. with potentially higher returns than bonds or money market accounts.
International markets encompass any type of stock trading outside U.S. borders, including emerging and frontier markets such as those in China, India, Brazil, Russia and South Africa. Investing in these regions carries risk due to currency fluctuations and political instability. However, they can also provide significantly higher potential returns. Researching international markets before investing can help reduce losses due to unforeseen global events outside your control.
Maturity lengths
Maturity length is the time until the investment reaches its full potential, either through the payment of principal and interest or the sale of the security.
Generally, shorter maturities are less risky because there is less time for something to go wrong; however, they also tend to have lower returns. Longer maturities, on the other hand, offer higher potential returns but come with more risk since there is a greater chance that something negative could happen during that timeframe.
Market capitalization
Market cap measures the size of a company by calculating its share price multiplied by its total number of shares outstanding. Generally speaking, smaller companies have lower market caps (less than $2 billion), while larger companies have higher market caps (more than $10 billion). Small-cap stocks can potentially provide higher returns due to their higher risk levels and increased potential for growth. However, they are also more volatile and may not suit every investor. Large-cap stocks may suit you if you favor stability since these companies tend to be well-established with more resources for research and development.
Risk profiles
Risk profiles can help you assess how much you're willing to take on in terms of risk to possibly achieve greater returns over the long run. A well-diversified portfolio will include different asset classes with varying risk levels, so you're not overly exposed to any single type. These asset classes may include stocks, bonds, mutual funds, exchange-traded funds (ETFs), real estate, commodities and cash equivalents.
Each has its own unique set of risks, from market volatility and interest rate fluctuations for stocks and bonds to geopolitical instability or natural disasters for commodities or real estate. Understanding these risks can help you allocate funds within your portfolio. Pay attention to the timing of your investment decisions, as market trends can change over time.
Why diversify your investments?
Almost without fail, risk management is the primary benefit of diversification. And indeed, diversification is fundamentally about managing the diversification of risk. But a different way to think about it is this:
A diversified portfolio helps you optimize your growth by managing your risk.
We'd all like to think of ourselves as savvy investors. We all want to buy the next Amazon.com Inc. NASDAQ: AMZN or Alphabet Inc. NASDAQ: GOOGL for a few pennies per share and then just sit back and watch our portfolio grow and grow. However, you know that investing doesn't work like that. Investments tend to follow Newton's third law of motion: For every action, there is an equal and opposite reaction.
Markets go up and down, and sometimes, they can swing wildly in opposite directions on the same day. When they do, you need a plan to balance your winners and losers. When you do this, your investments will continue to grow over time, independent of what the market is doing.
Another benefit of diversification is that it forces you to set priorities and allocate your money based on them. For many investors, especially during a bull market, there is a certain thrill in chasing returns. You determine what investments performed well in the last month, quarter, year, etc. and move money to "chase after" those gains. However, as most investors quickly learn, this risky diversification strategy often leaves them zigging when they should have zagged.
The opposite of the aggressive investor is the investor who wants to avoid all risks. So, they keep too much of their portfolio in bonds and cash and miss out on the gains they can get during bull markets.
In both cases, many times, it's because these investors have no real plan.
They don't know the definition of diversified. Creating and maintaining a diversified portfolio requires discipline. Aggressive investors may feel anxious about missing out on returns in a red-hot market. Conservative investors may get nervous when the market is going through a correction. But, in both cases, showing a commitment to diversification is a proven way to help all investors meet their goals.
How to diversify your portfolio
There are many different ways to diversify your portfolio. The goal is to spread your investments across various categories, including stocks, bonds and cash. This helps to reduce risk while also increasing your chances for a successful investment.
Step 1: Understand your risk tolerance.
Every investor has their level of comfort in taking on risk versus potential rewards; understanding yours will help ensure you don’t get in over your head. Are you aggressive or conservative? Aggressive investors typically focus on higher-risk investments with the expectation of more significant returns, while conservative investors look for lower-risk investments with steady returns.
Step 2: Decide which types of investments you want.
Typically, a diversified portfolio should include stocks, bonds and cash equivalents. Each asset class has its risks and benefits, so understand how they work.
Step 3: Determine percentages.
Next, determine the percentage of each asset class you'd like in your portfolio; for example, 25% stocks, 25% bonds and 50% cash equivalents. Depending on your age and risk tolerance levels, your mix could differ. When in doubt, consult a financial advisor who can provide professional advice tailored to your situation.
Step 4: Start investing.
You can purchase individual securities such as stocks or bonds from a broker or mutual fund company or buy index funds that track the performance of particular markets, such as the S&P 500 or Dow Jones Industrial Average. Investing in multiple funds exposes you to different markets without purchasing individual securities.
Step 5: Monitor your portfolio.
As market conditions change and new opportunities emerge, you might have to adjust your holdings by adding new diversified investments or selling off the ones you have. This ensures your investments remain balanced and continue to meet your financial goals in the long run.
Measuring diversification
When diversifying your portfolio, start with figuring out how much risk you're taking and what type of return you can expect. You can use several indicators to determine the level of investment diversification strategy to use in your portfolio.
Correlation coefficients
A correlation coefficient indicates the degree to which two securities move with each other. If two securities move up and down together, they have a positive correlation; if they move in opposite directions, they have a negative correlation.
A perfect correlation would be 1, while an ideal anti-correlation would be -1. Generally speaking, the higher the correlation between two assets is, the more risk you are taking by holding them both in your portfolio.
Beta
Beta measures how volatile an asset is compared to a benchmark index such as the S&P 500 or Dow Jones Industrial Average. A higher beta means that an asset is more volatile than the index; conversely, a lower beta means that an asset is less volatile than the index. Holding assets with different betas helps reduce portfolio volatility and increase diversification.
Diversification ratio
The diversification ratio considers various factors, such as correlations between assets and their betas, to calculate an overall score for portfolio diversification. The higher this score is (with 100 being ideal), the more diverse your portfolio. The diversification ratio can provide an easy way to get an overall picture of your portfolio's level of diversification at any given time.
Example of a diversified portfolio
In our portfolio diversification examples, we've constructed a portfolio with four different asset classes: 25% stocks, 25% bonds, 25% real estate and 25% cash. Each asset class has been further diversified within itself to reduce risk. For example, the stocks in our portfolio are composed of large-cap blue-chip companies like Apple Inc. NASDAQ: AAPL, mid-cap growth companies like Clover Health Investments Corp. NASDAQ: CLOV, small-cap value companies like Shutterstock Inc. NASDAQ: SSTK and international equities like Shoprite Holdings Limited OTCMKTS: SRGHY.
We've also included bonds from both federal and corporate issuers to provide stability in our portfolio, such as U.S. Treasury Bonds and International Business Machines Corp. NYSE: IBM financials.
Including real estate investment trusts (REITs) helps us gain exposure to the real estate market without purchasing properties outright. Our real estate holdings include residential and commercial properties, with a mix of rental income and capital appreciation potential.
Finally, to ensure liquidity, we've kept a portion of our portfolio in cash equivalents such as money market funds and high-yield savings accounts.
Using the diversification ratio, we've calculated that our portfolio receives a score of 82 out of 100 for diversification. While there's room for improvement, our portfolio is still well-diversified across multiple asset classes and securities.
By investing in a mix of these four asset classes — stocks, bonds, real estate and cash — we have balanced growth and stability and increased our overall rate of return while minimizing risk.
Pros and cons of diversification
Diversification is a popular, tried-and-true strategy for investors that rarely steers you wrong. However, like any strategy, it isn't perfect and has pros and cons.
Pros
There are many pros to cultivating the diversification of a portfolio, such as:
- Diversification helps reduce overall portfolio risk. By investing in various asset classes, you're spreading out your risk so that if one asset class underperforms, the other assets may be able to pick up the slack and help offset losses.
- Diversification can also help smooth out returns over time. By choosing different asset classes, you're not as exposed to extreme price fluctuations which can help avoid large losses during market downturns.
- Diversification gives you more options and reduces the chances of experiencing a large loss. It also gives you more flexibility when adjusting your portfolio due to changing market conditions.
Cons
Of course, like any strategy, diversification has some cons, such as:
- Investing in multiple asset classes requires more time and effort than if you were to choose just one. You have to closely monitor all the markets and conduct research on each investment to make sure your portfolio is properly diversified.
- Diversification is not a free lunch. It tends to lower your expected return since you won't benefit from any outsized returns from any single asset class but will receive average returns from multiple assets.
- Diversified portfolios can still see risks because of hidden correlations between assets or poorly timed investments. This means that even with diversification, you can still experience significant losses if you're not careful.
Risks of overdiversification
If a little diversification is good, is it possible to get too much diversity in your portfolio? The answer is yes, and here’s why. Trying to "micro-diversify" gets us into a situation where we can’t see the forest for the trees. We focus so much on diversifying inside one asset class that we forget about others.
Diversification is about finding an investment mix that's working for you. Part of an investment plan working for you is your ability to easily see and understand how your investments are adding to your risk and your reward.
A Diverse portfolio: Key for minimizing risk and maximizing returns
When managing risk and maximizing returns, diversification is the strategy by which all other strategies are measured. Allocating your assets in a way that considers both risk tolerance and return potential is key to long-term success.
The primary purpose of portfolio diversification is to spread your money across various asset classes (such as stocks, bonds, mutual funds and real estate) to minimize risk and maximize returns. By diversifying, you'll be exposed to less volatility while still earning returns from the asset class as a whole. This can help protect you against market downturns, with some assets offsetting losses experienced in others.
What is the benefit of portfolio diversification in your investments? Spreading your investments across multiple asset classes and different types of securities, you can balance risk and reward while still having the potential to earn higher returns than if you invested in just one asset class. The key is to find the right mix of investments that works for you and your goals while keeping a close eye on how each asset is performing.
Diversifying across investment styles — such as value and growth investing — can also help reduce risk and improve your overall returns.
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