Portfolio Diversification Explained: Definition, Importance, Strategy

Investing is the key to building wealth for most of us. Investment diversification is an important tool to help investors achieve the proper balance between growth and risk for their situation. Diversification is achieved through the allocation of your investments among various types, including stocks, bonds, and cash.

Looking to enhance your net annualized return? Diversify beyond the stock market with Yieldstreet - the leading platform for private market investing.

What does it mean to diversify your investments?

Investment diversification is akin to the old saying, “Don’t put all of your eggs in one basket.” It is often accomplished by using asset allocation across your investment portfolio. As the Securities and Exchange Commission explains it, “Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The process of determining which mix of assets to hold in your portfolio is a very personal one. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.”

In looking at diversifying your portfolio, here are some things to consider.

Diversify across asset classes

Asset classes—such as stocks, bonds, and cash—generally behave differently under similar market and economic circumstances. Within a broad asset class such as stocks, there are sub–asset classes, which include large, small, and mid-cap stocks. There are also different styles, such as growth, value, and a blend of the two. There are domestic and international stocks. Within the international stock umbrella there are stocks from both developed countries and emerging markets.

There are different types of bonds as well. Real estate is an asset class, as are other alternatives, including crypto and precious metals. Websites such as Yieldstreet—which focuses on private investing beyond the stock market—and Happy Nest, which links you to real-estate investing opportunities, can be good places to learn more about alternative investing opportunities.

In determining the right asset allocation for your portfolio, you will need to consider the overall potential risk and return. Additionally, you will want to look at how different asset classes correlate with one another.

These are tasks you can do for yourself, if you have the knowledge, or you can engage the services of a financial advisor. SmartAsset or Wiseradvisor are sites that can help you locate an advisor who fits your needs.

Diversify globally

Diversification among stocks and bonds of companies and other entities headquartered in the United States and those located abroad provides another level of diversification. One reason is that the relative value of the U.S. dollar to other currencies will by itself impact the return on these securities for U.S. investors holding them.

Add to this the inherent differences in the economies of other countries and their influence on stock prices and bond returns, and you have additional diversification before even looking at the companies behind these securities.

Diversify across industries and sectors

Especially for those investing in stocks, industries and sectors can have a profound impact on the performance of stocks issued by companies in those sectors. For example, the factors that might influence the performance of a stock in the technology sector could be vastly different from those impacting stocks in the energy sector.

Diversify across bond types

The price of a bond usually moves inversely to the direction of interest rates. All else being equal, the price of a bond will fall when interest rates rise and rise when interest rates fall.

Bond prices in the secondary market are affected by a number of factors, including:

• The length of time until the bond matures. Bonds with a longer time until maturity are more sensitive to the direction of interest rates.
• The credit quality of the bond issuer. Bonds with a lower credit quality will generally be more sensitive to the direction of interest rates.
• The rate of exchange. Bonds issued outside of the United States may be impacted by the relative value of the U.S. dollar to the currency of the country where the bond was issued.

Diversify using mutual funds and ETFs

Mutual funds and exchange-traded funds (ETFs) can be excellent tools for diversifying your portfolio. Most mutual funds and ETFs are invested along the lines of a specific asset class, whether stocks, bonds, or cash. Some funds are a mix of different asset classes; these balanced funds generally invest specified portions of the fund in stocks and in bonds.

Diversification can be accomplished by holding several mutual funds and ETFs. This might include an index fund tracking the S&P 500 or the total U.S. stock market. Other funds might include one or two bond funds, a fund tracking the non–U.S. stock market, and a few others.

Not only do mutual funds and ETFs allow for diversification across asset classes; these funds also hold a number of stocks, bonds, or other securities, offering yet another level of diversification.

Lastly, investing in mutual funds and ETFs can be a way for an investor who may not have a large amount to invest to diversify in a more cost-effective way than by using individual stocks and bonds.

Why is it important to diversify?

Different types of investments behave differently under various economic and market conditions. Diversification among different asset classes and types of investments can help to mitigate investment risk.

For example, the correlation between U.S. large-cap stocks and bonds is 0.26, according to the JP Morgan Asset Management Guide to the Markets. This means that 26% of the return of these two types of assets are based on similar factors, but 74% of the factors impacting their returns are not closely related.

The implication is that when U.S. stocks are undergoing a period of negative returns, bonds may perform differently because of their low correlation with each other. Overall, different asset classes may have higher or lower correlations. Having a portfolio that includes a variety of asset classes and investment types can help investors fine-tune the amount of risk in their portfolio.

Pros and cons of investment diversification

Pros

• Proper diversification can help enhance the risk-adjusted returns of a portfolio.
• Diversification can help investors mitigate losses during periods of stock market and economic uncertainty.
• Different asset classes and types of investments perform differently at different times and are based on different impacts of certain market conditions. This can help minimize overall portfolio losses.
• Diversification can help to preserve capital for older investors in or nearing retirement.

Cons

• A diversified portfolio might be difficult for an investor to manage if there are too many holdings to monitor effectively.
• Properly diversifying a portfolio can be expensive, thanks to fees incurred when buying certain types of investments.
• While helpful in reducing portfolio risk, diversification does not eliminate it.

How diversified should your portfolio be?

There is no one right answer to this question. At the very least you will want to have some investments in your portfolio that are not highly correlated with the rest of your holdings.

Stocks are often the core asset in many portfolios. Based on the level of risk with which you are comfortable and your investing time horizon, you may want to include some investments in assets such as bonds, precious metals, or commodities—all of which have a low correlation with stocks. Even among stocks, foreign stocks, including emerging markets stocks, have a relatively low correlation with large-cap U.S. stocks.

Using mutual funds and ETFs that focus on several different asset classes is a solid approach to diversification. However, it's important to understand what these funds hold. It is not uncommon for investors to hold a handful of mutual funds and ETFs thinking they are well diversified, when in reality the different funds may contain many of the same stocks and bonds as underlying holdings.

How to develop a diversification strategy

The first step is to assess your situation. Look at factors such as your age, the time until you will need the money, and your risk tolerance.

A number of sites offer asset allocation tools of various types that can help you decide how much to allocate to stocks, bonds, and other asset classes. SmartAsset takes this a step further and will match you with a financial advisor who can help with this process. A financial advisor will have the tools, knowledge, and experience to help you properly diversify your portfolio based on your personal situation.

Robo advisors can also be a source of professional guidance. They will allocate your assets and suggest investments based on the information you supply to them and their investment algorithms. Typically, they use ETFs to implement their asset allocation recommendations.

For instance, the M1 Finance is an excellent example of how automated investment platforms can provide professional guidance. M1 utilizes the information you provide and its sophisticated investment algorithms to allocate your assets and suggest appropriate investments, so you can benefit from the convenience and expertise of a robo advisor while still having control over your investment decisions.

Do you need a minimum amount invested?

There is no minimum amount needed to diversify your portfolio. All you need is enough to purchase a variety of investments.

One way to achieve this efficiently is to use mutual funds and/or ETFs. You can invest across a number of asset classes with a relatively minimal overall investment. Some mutual funds may require a minimum initial investment into the fund.

Frequently asked questions (FAQs)

Is it always beneficial to diversify your portfolio?

Different investors have different objectives and risk tolerance levels. Some investors prefer to concentrate their investments into one or a few holdings that they feel will outperform the markets over time. For investors like these, a diversified portfolio probably would not make sense.

What is an example of a diversified investment portfolio?

A diversified investment portfolio can take many forms. Fidelity Investments offered these examples of diversified portfolios based on four different investor risk levels.

These are just examples. The level of diversification that’s right for you will depend on your unique situation.

Does portfolio diversification eliminate investment risk?

While diversifying your portfolio can help reduce investment risk, diversification does not eliminate it. Stocks, bonds, and other investments still carry the risk of losing money in certain market and economic conditions. Having a diversified portfolio spreads the risk exposure among different types of investments that may react to various market conditions in different ways, but it is virtually impossible to eliminate risk when investing.