What Is Diversification? How It Works, Benefits

What is diversification?

Diversification is an investing strategy in which the investor spreads investments across different types of asset classes in order to reduce the risk of loss. Because different asset classes react in different ways to market changes, diversification helps reduce the chance that one market event or one investment’s poor performance will decimate the investor’s portfolio.

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How diversification works

Diversification may look different for each investor. Your risk tolerance and how long you plan to invest are just two factors that affect your strategy. But in general, to achieve diversification, investors blend dissimilar assets together (like stocks and bonds) so that their portfolio does not have too much exposure to one individual asset class or market sector.

The four main general asset classes in an investment portfolio are stocks, bonds, cash and alternative investments.

1. Stocks (or equities). These instruments allow investors to own a piece of a company. Stocks can offer high long-term gains but can be volatile.

2. Bonds (or fixed income) pay interest to investors who lend money to a company or government. Bonds are income generators with typically relatively modest returns. Generally, bond prices have an inverse relationship with stock prices.

3. Cash (or cash equivalents) is the money in your savings account, pocket or hidden under your pillow. In terms of risk and return, cash is low on both counts. Cash can buffer volatility or unexpected expenses and acts as “dry powder” to invest during opportune times.

4. Alternative investments (“alts”) include things such real estate, private equity, crypto, art or precious metals. Pensions, annuities and insurance can also factor in. These asset classes usually have a lower correlation to the stock market and can, as such, be effective in aiding diversification. However, they can be relatively risky and complex.

For example, say you invest all of your money only in Apple stock (AAPL). This would mean that your asset allocation is 100% equity (or stock) and all in the technology sector. This is risky because if Apple’s stock price drops, your whole portfolio suffers. You might diversify within the technology sector by investing in other tech stocks, but if the whole technology sector is negatively affected, your portfolio might still take a big hit.

To diversify to portfolio, you may want to buy stocks in other sectors. You may also want to buy bonds or other fixed-income securities to protect against a stock market correction (bond prices tend to rise when stock prices decline).

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Pros and cons of diversification

Benefits of diversification

Diversification is a simple way to reduce risk. By choosing not to put all of your eggs in one basket, you protect your portfolio from market volatility.

Also, the net effect of diversification can be relatively slow and steady performance, as well as smoother returns that don't move up or down too quickly. That reduced volatility puts many investors at ease.

Disadvantages of diversification

The trade-off of diversification is that you never fully capture the startling gains of a shooting star. An investment that really takes off will be tempered by other investments in your portfolio that are not performing as well.

Also, although diversification is an easy way to reduce risk in your portfolio, it can’t eliminate risk altogether. Investments are subject to two broad types of risk:

1. Market risk (systematic risk): These risks come with owning any asset, even cash. The entire market may become less valuable for all assets for many reasons, such as a pandemic or war.

2. 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 reduce asset-specific risk by diversifying your investments. However, there’s just no way to get rid of market risk via diversification. It’s a part of investing.

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How to diversify a portfolio

There are several methods that investors can use to diversify a portfolio.

By industry or sector

The economic cycle affects every business differently. As a result, investing in companies in all kinds of industries is one way to diversify.

Some sectors are cyclical, meaning the company’s performance moves in sync with the economic cycle. Examples include consumer discretionary (clothing, electronics, cars, etc.), financial services, basic materials and real estate, where demand grows as the economy gets stronger. Some sectors are defensive, meaning they are less affected by the economic cycle. Examples include consumer staples (groceries, tobacco, etc.), utilities, and health care — necessities that tend to be consumed at all times.

By size or market capitalization

Market cap is the total value of a company's tradable stock (number of outstanding shares x price per share). Larger companies tend to be more stable and can weather economic downturns more easily, but they also tend to have less growth potential versus their smaller counterparts.

By style (growth vs. value)

Growth stocks are often relatively expensive but may havehigh future growth potential. Value stocks are companies whose stocks are “on sale” or seem underpriced or undervalued.

By credit quality

Bonds offer different levels of creditworthiness or safety. For instance, Treasurys are relatively low-risk because it’s unlikely the U.S government will go bankrupt.

By maturity

Compared to short-term bonds, longer-term bonds may earn higher returns because they are subject to more interest rate risk.

By type of issuer

Integrating bonds from various issuers can help mitigate the effects of one issuer type becoming more likely to default on debt repayments. Bond issuers include the U.S. government (such as Treasurys), municipalities, corporations and more.

By geography

Different countries have different economic cycles, so for some investors it makes sense to have exposure to both domestic and international markets. International or foreign markets are further classified as developed and emerging. Developed markets (e.g., European nations, Australia, Japan, Singapore, etc.) tend to be less volatile (but may have lower growth potential), whereas emerging markets (e.g., Brazil, Russia, India, China, etc.) tend to be more volatile (but may have higher growth potential).

By active vs. passive method

You can purchase many securities through mutual funds, index funds or exchange-traded funds (ETFs). In active funds, a portfolio manager picks which stocks to include in the fund. In passive funds, the goal is to buy securities that mimic an underlying index, such as the S&P 500. Passive funds often can outperform active funds during market upswings, but active funds can have better downside protection during market downturns.

Other options include target-date funds, which typically shift assets automatically from stocks to bonds as the investor approaches retirement age.

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Creating a diversification strategy

Creating a diversification strategy can be tricky, 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. Talking to a qualified financial advisor can help.

Here's a diversified portfolio example that shows how diversification might look in your own portfolio.

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