What is diversification? A portfolio strategy that uses a variety of investments to limit risk
Diversificationis an investment strategy that means owning a mix of investments within and across asset classes.
- The primary goal of diversification is to reduce a
portfolio's exposure to risk and volatility.
- Since it aims to smooth out investments' swings, diversification minimizes losses but also limits gains.
If you're familiar with the proverb "Don't put all your eggs in one basket," you have a basic understanding of diversification in investing.
Diversification is all about spreading out your money into multiple investments, and multiple kinds of investments. The idea is that your portfolio will be protected if one particular asset, or group of assets, loses money.
For example, if you put all of your money into one stock, your entire investment could be wiped out if that company fails. Or (less dire scenario) fail to grow much if that firm or its industry falls on hard times. However, by investing in 20 stocks, you spread out your risk. Even if five stocks go down, you may still make money overall if the other 15 appreciate in value.
Diversification can't completely eliminate risk — when it comes to investing, almost nothing is 100% safe. But it can significantly reduce your exposure to risk. Different investments are subject to different influences and different degrees of volatility (price swings). In a well-diversified portfolio, they balance each other, keeping your finances and their growth on an even keel.
What is diversification?
When financial experts talk about diversification, they can be referring to a variety of strategies. You can diversify with an eye towards:
- Risk level (from low to high)
- Investment needs (income, appreciation, aggressive growth)
- Liquidity (from pure cash to less marketable holdings)
- Time horizon (from immediate return to long-term)
Of course, there can be overlap among these diversification goals: Aggressive growth stocks are ones you would want to keep for the long-term; highly liquid investments tend to be low-risk. Whatever the strategy, they all have the same aim — shield a portfolio from the bumps and bruises of volatile moves, especially downward ones.
And they're executed in fundamentally the same way: by the types of assets you invest in.
Diversification across asset classes
One of the core features of diversification is called asset allocation — which simply means, investing in different kinds of financial instruments, aka assets. When it comes to investing, assets fall into two major categories:
- Traditional (what we usually think of as investments — pure money vehicles, like stocks, bonds, and cash)
- Alternative (often more tangible things, like property, or exotic instruments, like derivatives)
Within these two broad areas are several sub-categories, or asset classes. Here are the leading ones for individual investors:
To be considered or well-diversified, a portfolio —or at least, your financial holdings overall — should contain assets from at least three of these classes. For example, real estate could be represented by the home you own.
Diversification within asset classes
In addition to diversifying across asset classes, it's important to consider diversification within asset classes. This is especially true with something like stocks, which is probably the largest, most varied of the asset classes out there.
You can parse stocks in a variety of ways. One of the most common, when it comes to diversifying, is to consider them by sector — that is, the industry they belong to.
Only investing in Facebook, Google, Apple, and Microsoft stock, for example, would be less than ideal since all of these companies are part of the Technology sector, and so are affected by the same factors, have the same strengths and weaknesses. Investing in stocks of other sectors such as Energy, Industrials, or Financials, could help you build a more well-rounded portfolio — because they would possess different characteristics, and might respond differently under different economic conditions.
The importance of a diversified portfolio
Diversification offers safety by buffering the shocks that can beset particular assets. But what's especially interesting is that it can help investors limit their risk without significantly diminishing long-term returns. In a study of average portfolio returns and volatility from 1926 through 2015, Fidelity Investments compared the performance of portfolios diversified in several different ways, including "aggressive" (mainly invested in stocks, for strong growth) and "balanced" (more evenly divided between bonds for income and stocks for appreciation).
Fidelity found that the swing between best and worst 12-month returns was 79.64 percentage points higher for "aggressive" portfolios than "balanced" ones. Yet despite dramatically higher volatility, the aggressive portfolios only outperformed in average annual returns by 1.69%. So for a trade-off of 1.69% in lower returns, you could have enjoyed a smoother ride with far fewer sharp nosedives along the way.
It's important to point out, however, that even the most thoughtful diversification strategies can't completely eliminate losses — particularly in the short-term. In the Fidelity study, even the most conservative portfolios suffered a loss of 17.67% during their worst 12-month spans.
Drawbacks of diversification
Diversification is, in many ways, a no-brainer. But of course, there are always drawbacks. Here are two to keep in mind:
- Diversification, by design, limits your returns to the "averages." You're betting on a lot of companies/types of investments with the goal that you'll have more winners than losers. But the clunkers will drag down the stars. So while diversified portfolios should see fewer massive downturns than aggressive (less diversified) portfolios, they're also less likely to see extreme highs.
- Diversification can be costly and time-consuming. It can take a lot of effort to research dozens or hundreds of stocks and bonds. Plus, buying a variety of different investments can be expensive, especially for the individual investor.
The second reason is why mutual funds, index funds, and exchange-traded funds (ETFs) have gotten to be the go-to for individual investors. Buying into these baskets of securities help you achieve instant diversification — not only within asset classes, but across them.
And investors can even choose to diversify their fund holdings into funds with varying risk levels.
For example, below are three popular mutual funds types:
- Growth funds: Invest in companies that are expected to enjoy faster-than-average gains and tend to be the most volatile.
- Income funds: Invest primarily in dividend-paying stocks and focus on long-term income rather than short-term capital appreciation.
- Balanced funds: Offer the most diversification by investing in stocks, bonds, and cash equivalents, for both capital appreciation and income.
The financial takeaway
Diversification is a simple concept, even if the ways of achieving it are many. And it's a fluid thing. Diversifying your portfolio isn't a "set it and forget it" activity. As your goals change or you age, it's likely that you'll need to tweak your asset allocation.
Here are three other tips for diversifying your portfolio:
- Keep a close eye on your investing costs: Fund costs, trading commission, and advisory fees can cut into your overall returns. Try to avoid costly fund transaction fees and loads (commissions) and be sure to compare fund expense ratios.
- Consider target date or asset allocation funds: Asset allocation mutual funds or ETFs invest in a preset mix of stocks and bonds (i.e. 80/20, 70/30, or 60/40) at all times and rebalance automatically. And target-date funds take things a step further by consistently adjusting towards a more conservative mix as you get closer to retirement.
- Reassess regularly: As certain assets in your portfolio overperform (or underperform), your portfolio's weightings can move away from your target allocation. By rebalancing your portfolio once or twice per year, you'll ensure that your asset allocation is always consistent with your tolerance for risk.
Bear in mind that "the primary goal of diversification isn't to maximize returns. Its primary goal is to limit the impact of volatility on a portfolio," as the Fidelity study notes. In other words, diversifying is a defensive move. But it's one that every investor should make, at least to some degree.
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