Diversification: An Easy Way to Reduce Your Investing Risk

Investing
Diversification Is a Must-Have for Investors

Diversification is the simplest way to boost your investment returns while reducing risk. It may sound like an impossible investing goal, like juggling flaming pitchforks, but it’s actually an easy — and critical — one for new and passive investors to achieve.

There are a variety of tools at your disposal that help make it easy to diversify your retirement or brokerage accounts or other investment funds. For example, simple, low-cost, “set it and forget it” exchange-traded funds 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.

What is diversification?

Diversification means owning a range of assets across a variety of industries, company sizes and geographic areas. It’s part of what’s called asset allocation, meaning how much of a portfolio is invested in various asset classes. Investors have many options, and each has advantages and disadvantages, responding differently across the economic cycle. Some of the most common types of assets that are included in retirement plans or brokerage portfolios include:

  • Stocks offer the highest long-term gains but are volatile, especially in a cooling economy
  • Bonds are an income generator with modest returns but are weak in a hot economy
  • ETFs or mutual funds can offer a combination of other asset classes and immediate diversification

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 — about 10% annually. Not too shabby. However, over shorter time periods, that return can vary widely.

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.

» MORE: How to buy stocks

The fine print on diversification

While diversification is an easy way to reduce risk in your portfolio, it can’t eliminate it. Investments have two broad types of risk:

  • Asset-specific risks: 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.
  • Market risks: 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.

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 diversify your 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. But with ETFs and mutual funds, you have great options to diversify safely and quickly — and you’ll likely outperform the vast majority of actively managed portfolios anyway.

Here’s how diversification might look in your own portfolio.

One of the best options for passive investors is an ETF or mutual fund based on the S&P 500 index, a broadly diversified stock index of America’s 500 largest companies. It’s diversified by industry and size, and even though the companies are based in the U.S., they generate a huge portion of their sales overseas. So you’ll get the benefits of immediate diversification in 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. Still, investors with long time horizons — seven years or more — can see huge upside in owning an all-stock portfolio.

Virtually all the large investment companies offer some index and bond funds, and they’re readily available for individual retirement accounts and 401(k) plans. Usually, these funds have low expense ratios, too.

» MORE: How to invest your IRA

Other options include target-date funds, which manage asset allocation 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.

James F. Royal, Ph.D., is a staff writer at NerdWallet, a personal finance website. Email: jroyal@nerdwallet.com Twitter: @JimRoyalPhD