Table of Contents:
- Understanding the diversification meaning
- Diversification investment strategies
- Pros and cons of diversification
- Diversification Q & A
- The bottom line
When we start investing as a beginner, one of the most common goals is to build wealth, so it’s important to understand the best ways to manage and mitigate the risks of investing. One way to do that is through diversification.
According to Investor.gov, the definition of diversification states it’s a strategy to put your money in several different investments, so if one isn’t performing well, the others will minimize overall losses. In other words, diversification can be summarized using the phrase, “don’t put all your eggs in one basket.”
So, what is diversification? It’s an investment strategy focused on managing risks by spreading investments among various asset types and industries in a portfolio to minimize exposure to dips in any single investment.
The logic is that a well-diversified portfolio can offer higher long-term returns and lower the risks of holding any individual security. The strategy is that if you diversify among asset classes and markets, there’s even less risk because if one part of your portfolio is underperforming, the other can make up for those losses.
Key Takeaways:
- Diversification can minimize the risks of investing because you spread your money around in various asset classes and industries.
- A diversified portfolio includes investments within asset classes and across classes, in various industries—and in both foreign and domestic markets.
- One goal of diversification is to reduce the volatile nature of investing and balance out investments for long-term growth.
Understanding the diversification meaning
We know that diversification in various securities can help to shield us from losing everything if one investment doesn’t perform well.
When we have a diversified portfolio, we offset adverse events in one company or industry. That’s why investing in a combination of stocks, bonds, mutual funds, exchange-traded funds (ETFs), and money markets across asset types, industries, and markets is a solid investment strategy.
So what exactly does it mean to have a well-diversified portfolio? When building a diversified portfolio, one of the rules of thumb is to spread investments among 25 or more securities that can even out unsystematic risks, meaning that positive performances in some stocks can mitigate any negative performance of others.
Examples of diversification
For example, let’s say you love XYZ company and decide it’s the only investment you need. But then, there’s a scandal around bad business practices and defrauding customers, and the stock drops significantly, leaving you and your belief in the company hanging out to dry with little to show for it.
Your friend, who was equally passionate about XYZ company, invested in it but also spread her money around and invested in a variety of additional markets and asset types. So, when XYZ stocks dropped, her portfolio wasn’t affected beyond a slight dip.
Your friend was able to counterbalance her portfolio and didn’t worry about the drop in XYZ stocks because she didn’t put all her eggs in one basket. You, on the other hand, have lost everything.
Diversification investment strategies
When creating a diversification strategy, it’s essential to buy in a range of asset classes that meet your risk tolerance and goals for returns. Asset classes consist of:
- Stocks & bonds
As two of the most popular asset classes, stocks and bonds offer a variety of options. Investing in more stocks can provide higher returns but with more risk. Bonds are considered less volatile with slower growth potential.
- Industries
Another classification in the stock market that offers diversification is the various industries and sectors. The S&P 500 consists of 11 different industries that include:
- Financial
- Health care
- Energy
- Utilities
- Industrials
- Consumer services
- Technology
- Consumer staples
- Materials
- Real estate
- Consumer discretionary
By diversifying across industries, you balance out your investments and mitigate risks. When one industry experiences losses, others may be enjoying gains that can even out investment risks.
- Geography
The location of the companies can also be a factor in diversification. Events in the U.S. may not impact companies in emerging or developed markets. Many companies have headquarters in the U.S. but do business globally, offering different returns depending on the location.
- Growth
When a company is new, growth can happen at a faster rate than older, more established companies and provide different risks and returns. Some companies also have a higher valuation than others which can affect returns.
- Mutual funds
Mutual funds can offer a well-diversified portfolio with a single fund called a target-date retirement fund that can provide an easy strategy for managing risk.
Asset diversification
When diversifying assets, the challenging part can be choosing and allocating the right mix at the right risk tolerance to meet your financial goals.
One of the most important aspects of investing is understanding your own risk tolerance, as it will be an important part of the decision-making process. For example, suppose you can tolerate riskier investments. You may allocate a bigger portion of your portfolio to those investments as they can generally offer higher rewards. But if you want less risky assets, allocating a more significant amount to those investments may be a better option.
The asset classes to include in a well-balanced portfolio can consist of:
- Stocks and equities – shares in a publicly-traded company.
- Bonds – represent a fixed-income loan made to an investor by corporate and government lenders.
- Exchange-traded funds (ETFs) – a basket of investments included in index funds.
- Real estate – includes property, land, natural resources, water and mineral deposits, and agriculture.
- Cash and cash equivalents (CCE) – money markets, certificates of deposits (CDs), treasury bills, and short-term investments.
- Commodities – goods needed in the production of products and services.
There are two levels of diversification: those between asset categories and those within asset categories. While it’s important to spread your money among stocks, bonds, ETFs, money market, and other cash equivalents, you’ll also want to diversify within each asset category to include investments that perform differently under various market conditions. That way, you offset significant drops in any one category.
Diversification in foreign securities
Another level of risk mitigation in diversification comes from investing in foreign securities, which can provide a wide variation from U.S.-based securities, meaning that events that may affect the U.S. economy may not affect other countries in the same way.
When looking to diversify, most of us have what’s known as home country bias, which means we automatically look for investment opportunities in our own country. For those of us in the U.S., our investment exposure may be focused on U.S. investments. The problem is that we are missing out on the many global markets that can provide us with an even more diversified portfolio.
So how do we invest in foreign markets? The easiest way is by investing in ETFs and mutual funds, where you can invest in a variety of funds in one basket of investments that’s low cost with easy access.
Mutual funds and ETFs diversification
For most individual investors, creating a well-diversified portfolio can be challenging, so mutual funds can offer significant benefits. Buying shares in a mutual fund provides a way for individuals to invest in a diversified portfolio at a lower cost than if they were to buy each fund separately.
Mutual funds and ETFs allow investors to easily diversify their investments. Mutual funds spread investments among different asset classes, and ETFs provide narrower markets that aren’t easily accessible, such as international securities and commodities.
Pros and cons of diversification
Like all aspects of investing, diversification has both positive and negative consequences. Investing can be volatile, and since we invest to build wealth over time, it’s logical to mitigate risks through diversification.
We allocate assets into various asset classes and markets, all in the name of hedging our bets against underperforming investments with the counter-effect of those other investments minimizing the hit.
Still, diversification has pros and cons, and knowing them can help you make better decisions about creating your own investment strategy.
Pros of diversifying your investment portfolio:
- Risk management – Investing in different types of asset classes and markets mitigates overall risks. The chances are minimal that 2 or more asset classes would be significantly underperforming at the same time. So, diversifying helps offset significant losses.
- It helps us meet our financial goals – When we have a savings plan and a time goal to get there, we can set our allocations to meet those goals.
- Growth – Investing across asset classes offers opportunities for growth among the different sectors and markets to align with our goals.
Cons of diversifying your investment portfolio:
- Keeping track of rules – Asset classes can work differently, so knowing and understanding how they work is vital for making the best decisions to meet your goals.
- Tax implications – Investments can be affected by taxes so understanding costs, taxes, and rules for compliance is vital.
- Avoid mistakes – We know that diversification is valuable in investing. Still, we can lose the overall benefit and dilute our returns when we try to be too detailed in getting it right with the perfect mix and asset allocation.
- Investment costs – Both fees and charges can vary with asset classes. When choosing diverse investments, they can add up and diminish returns.
- Growth caps – Portfolio diversification may help reduce risks and keep returns balanced, but it can also limit chances for investment growth by limiting the high return of specific high-risk investment opportunities.
Diversification Q & A
Q: How is diversification defined?
A: Diversifying spreads out assets among various asset classes, markets, and stocks to reduce the overall risks of investing.
Q: Is diversification for beginners?
A: It’s important for all investors to understand diversification. When investing as a beginner, there’s a lot to learn, and one of the most important lessons is not to put all your eggs in one basket. By embracing diversification from the beginning of your investment journey, you can set investment goals with diversification in place.
Q: Is there a way to invest that makes diversification easier?
A: Exchange-traded funds (ETFs) are made up of various bonds and equities that offer a basket of diversified funds. There can be anywhere from 20 or more different funds across asset classes. Therefore, they are a good option for easily diversifying your portfolio.
Q: Are there mistakes that are common when it comes to diversifying your portfolio?
A: One of the most common mistakes is not diversifying enough. Many investors choose to invest in stocks of only popular companies in the same industry, such as technology, but if they don’t perform well, they don’t have other investments to mitigate those losses, so it’s important to choose different companies across asset classes and markets that align with your risk tolerance and overall investment goals.
Q: What types of investments should be included in a diversified portfolio?
A: Although there are many asset mixes available, some of the choices include large-cap and small-cap stocks, domestic and foreign stocks, bonds, cash, real estate, commodities, ETFs, and mutual funds, which are all options for creating a well-diversified portfolio.
Q: What are bonds, and are they safer than stocks?
A: Bonds are a debt that can be turned into a security that can be bought and sold. Bondholders can sell the bond and profit, but they can also lose money. And since they are a form of debt, they come with the risk of experiencing a default. So although some consider bonds to be safer than stocks, that isn’t necessarily the case in all circumstances.
The bottom line
Although investing is a valuable way to meet financial goals and create wealth, it’s also risky. One way we can balance the risks and rewards is by having a diversified portfolio that includes a variety of asset classes in both domestic and foreign markets that matches your risk tolerance.
Despite the benefits of diversification, it should be noted that investing can come with volatility. By spreading investments across and within asset classes, there’s a better chance of reducing some of those risks. However, there’s no guarantee of eliminating risks completely.
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