What is diversification?
Diversification is the act of spreading investment dollars across a range of assets to reduce investment risk. It's part of what’s called asset allocation, meaning how much of a portfolio is invested in various asset classes, or groups of similar investments. Say you invested only in different types of produce — apples, bananas, broccoli, and spinach — your general asset classes would be "fruits" and "vegetables."
Investors have many investment options, each with its own advantages and disadvantages. Some of the most common ways to diversify your portfolio include diversification by asset class, within asset classes and beyond asset class.
Diversification is the simplest way to boost your investment returns while reducing risk. And there are plenty of tools available that help make it easy to diversify your investment accounts.
Diversification by asset class
The three main general asset classes in an investment portfolio are stocks, bonds and cash.
Stocks (or equities) allow investors to own a piece of a company. Stocks offer the highest long-term gains but are volatile, especially in a cooling economy.
Bonds (or fixed income) pay interest to investors who lend money to a company or government. Bonds are income generators with modest returns but are usually weaker during an expanding economy. Generally, bonds have an inverse relationship with stocks.
Cash (or cash equivalents) is the money in your savings account, pocket or hidden under your pillow. Cash provides the least risk and thus the lowest return. Cash can buffer volatility or unexpected expenses and acts as “dry gunpowder” to invest during opportune times.
There are other asset classes such as real estate (property), commodities (natural resources, precious metals) and alternative investments. These asset classes usually have lower correlation to the stock market and as such can be effective to aid in diversification.
Diversification within asset classes
After asset level diversification, investors can further the process by categorizing the main general asset classes into sub-classes or breaking them down into more detail.
Diversification beyond asset class
Diversification can extend beyond traditional asset classes found in typical investment accounts. Investment accounts have non-guaranteed returns since they are subject to market fluctuation. However, there are other product types such as pensions, annuities and insurance products that can provide guaranteed income streams and returns. Often, investors diversify their portfolio by spreading their investment dollars among these different product types as well.
Why is diversification important?
Diversification provides what professionals call a “free lunch” — reducing overall risk while increasing the potential for overall return. That’s because some assets will perform well while others do poorly. But next year their positions could be reversed, with the former laggards becoming the new winners. Regardless of which stocks are the winners, a well-diversified stock portfolio tends to earn the market’s average long-term historic return. However, over shorter time periods, that return can vary widely.
Below, the graphic from J.P. Morgan shows the variability of different types of investments from 2004 to 2018. Navigating the market’s fickle nature, the “asset allocation portfolio” (a diversified portfolio with a mix of investments) stays in the middle of the pack, achieving an annualized return of 6.2% over the time period and evening out the ride.
Owning a variety of assets minimizes the chances of any one asset hurting your portfolio. The trade-off is that that you never fully capture the startling gains of a shooting star. The net effect of diversification is slow and steady performance and smoother returns, never moving up or down too quickly. That reduced volatility puts many investors at ease.
Does diversification work?
While diversification is an easy way to reduce risk in your portfolio, it can’t eliminate it. Investments have two broad types of risk:
Market risk (systematic risk): These risks come with owning any asset — yes, even cash. The market may become less valuable for all assets, due to investors’ preferences, a change in interest rates or some other factor such as war or weather.
Asset-specific risks (unsystematic risk): These risks come from the investments or companies themselves. Such risks include the success of a company’s products, the management’s performance and the stock’s price.
You can radically reduce asset-specific risk by diversifying your investments. However, do what you might, there’s just no way to get rid of market risk via diversification. It’s a fact of life.
You won’t get the benefits of diversification by stuffing your portfolio full of companies in one industry or market. How terrible would it have been to own an all-bank portfolio during the global financial crisis? Yet some investors did — and endured stomach-churning, insomnia-inducing results. The companies within an industry have similar risks, so a portfolio needs a broad swath of industries. Remember, to reduce company-specific risk, portfolios have to vary by industry, size and geography.
How to build a diversified portfolio
Diversification may sound difficult, especially if you don’t have the time, skill or desire to research individual stocks or investigate whether a company’s bonds are worth owning. Most securities can be purchased individually or in a collection, such as through a mutual fund, index fund or exchange-traded fund (ETF). For example, simple, low-cost, "set it and forget it" ETFs or mutual funds — especially index funds and target-date funds — and other options such as robo-advisors can get a portfolio diversified quickly and safely while reducing risk.
Here's how diversification might look in your own portfolio.
A commonly used option for passive investors is an ETF or mutual fund based on the S&P 500 index, a broadly diversified stock index of 500 large, industry-leading American companies. It’s diversified by industry and even though the companies are based in the U.S., a significant portion of their sales is generated overseas. Buying the S&P 500 is an example of how you can gain benefits of immediate diversification with just one fund.
The downside: Such funds are concentrated in stocks. To gain wider diversification, you may want to add bonds to your portfolio. Plenty of diversified bond ETFs exist, and they could help balance out the volatility of a stock-heavy portfolio.
Virtually all large investment companies offer some index and bond funds, and they’re readily available for individual retirement accounts and 401(k) plans.
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Other options include target-date funds, which manage asset allocation and diversification for you. You set your retirement year, and the fund manager does the rest, typically shifting assets from more volatile stocks to less volatile bonds as you approach retirement. These funds tend to be more expensive than basic ETFs because of the manager’s fees, but they can offer value for investors who really want to avoid managing a portfolio at all.
With these options, you can achieve the benefits of diversification relatively simply and affordably.