Diversification provides income, growth and a measure of steadiness to an investment portfolio. Diversification should be reviewed and rebalanced on a regular basis.
Financial experts typically recommend diversification within and across asset classes and industries. For example, a stock portfolio should include stocks of different size companies and from distinct industries.
Diversification involves spreading your investment dollars across a number of different stocks, reducing the chance that one particular company will fail and a large loss will hit your portfolio. You can diversify within asset categories by size (large-, mid-, and small-cap stocks), geography (domestic and international), and industry and sector.
Some investors prefer to diversify even further within each asset category by investing in companies of different sizes and in companies in different sectors. This type of diversification is called “diversifying by exposure,” and it increases the chances that positive news will benefit a broad range of companies instead of just one.
Many individual investors find it difficult to create a well-diversified stock portfolio because of time and budget constraints. However, a variety of mutual funds and ETFs provide low-cost ways to easily diversify among stocks. There are also target-date funds that manage the asset allocation process for you, shifting from stocks to bonds as you near retirement.
Diversification reduces risk by spreading investments among many different asset classes. This protects against one investment failing, and it allows you to profit from market volatility because different types of assets respond differently (in opposing ways) to market influences.
Many professionals invest for specific financial goals, such as accumulating a large nest egg to enjoy retirement, paying a child’s college tuition in ten years or enjoying yearly vacations. Achieving these goals requires a variety of investment approaches, including diversification.
Diversification also reduces company-specific risks, such as those resulting from a radical change in leadership, legislation or acts of nature. To minimize these risks, a portfolio must be diversified by industry and include stocks from many different companies. It’s easier and cheaper than ever to achieve broad diversification with a diversified mutual fund portfolio or an ETF. The best online brokerages offer zero commissions for investors.
As the old saying goes, you should never put all your eggs in one basket. Diversification is a way to reduce the risk of big losses by spreading your investments among different asset classes and within each class.
Asset classes include stocks, bonds, and cash equivalents, with each carrying varying levels of risk. Stocks typically carry the highest level of risk, but offer higher potential returns. Bonds have lower risks and offer modest returns, and cash alternatives have the lowest risks but also offer the least return.
The more money you invest in the different assets, the more diversified your portfolio will be. However, as investments rise and fall in value over time, your diversified portfolio may become less diversified. To reduce this effect, it is important to periodically re balance your investment portfolio. See How to Rebalance Your Portfolio for guidance. This can be done by selling some investments and buying other types of investments, which may result in a capital gain or loss.
You can diversify at two levels: between asset classes (stocks, bonds and cash equivalents) and within each asset class. Diversification reduces the risk of your portfolio by spreading out investments that react differently to a specific market environment.
For example, investing in railroad stocks helps protect against changes to the airline industry. But you could also diversify within your industry by buying into technology or media companies. If consumers decide to stay home and stream content, then these types of companies will benefit.
However, time and budget constraints make it difficult for individual investors to create a fully diversified portfolio. That’s where a well-managed mutual fund or ETF can be helpful. Plus, you can buy and sell these funds for a fraction of the cost of a traditional stock or bond. You can even find zero commission options at major online brokerages.