You hear it from experts, planners and other investors: A diversified portfolio is key to weathering the market in the long term. But you may be confused as to whether your money is in fact diversified or not. Learn the benefits of a diversified portfolio, including a five-point checklist to achieving high returns with less risk. We also provide steps to take if your portfolio isn’t quite there.
A diversified portfolio is an investment portfolio that spreads your investments across a mix of different assets, rather than only one.
Let’s say all of your money is sitting in a savings account. In this case, you do not have a diversified portfolio — you’re invested on one highly liquid, low-risk investment.
Similarly, if your portfolio includes numerous investment property types — like houses, apartment and land — but no other kind of investment, it may be a diversified property portfolio, but it’s not a diversified investment portfolio overall.
The many the ways you can diversify your investment portfolio include:
|Asset type||Investments like cash, stocks, bonds, options, commodities and real estate.|
|Market sector||Investments in any of several industries within 11 generally accepted sectors: communication services, consumer discretionary, consumer staples, energy, financials, health care, industrials, IT, materials, real estate and utilities.|
|Objective||You can invest for growth, income, safety, value, hedging or speculation, among other reasons.|
|Asset size||Small, medium and large assets.|
|Asset location||Investment in different markets across the world, including North America, Europe, Asia, developed countries, emerging markets, etc.|
|Time horizon||Short-term, medium-term and long-term investment ideas.|
|Volatility||Assets with more or less inherent volatility than others, measured by its beta — a measure of risk.|
|Liquidity||How quickly you can find a buyer or seller. For instance, popular stocks can be bought or sold in seconds, while some real estate can take years.|
|Tax liability||You can place your money in both taxable and tax-advantaged investment accounts.|
|Type of analysis||You can diversify even how you pick your investments by combining fundamental and technical analysis.|
The main goal of diversifying your investments is to create a portfolio that achieves the highest returns at the lowest overall risk. A well-diversified portfolio can safeguard you against market volatility and cyclical market events while helping you to reach multiple financial goals at once, among other benefits.
Manage your risk.
Sage life advice says to avoid putting all your eggs in one basket. That also applies to investing, where investing all your money in one investment class could mean losing it all if that investment’s performance tanks. With a diversified portfolio, you’d lose only the money on your investments in that asset, rather than across your whole portfolio.
Say you invested only in American stocks. Your entire investment portfolio would be affected if the US market crashed. But if only a quarter of your portfolio was in stocks, the remaining three-quarters of your portfolio could provide the buffer to help you weather the storm financially.
Broaden your opportunities.
If you choose to invest in a particular asset class, diversifying your portfolio within that class gives you more opportunities to own a winning asset while also helping minimize risk to your investment portfolio as a whole. For example, investing across the healthcare, utilities, consumer discretionary and tech sectors gives you better odds of earning a positive return over time than if you were invested in just one of those sectors, as different sectors outperform the market at different times.
Reduce market volatility.
When you spread your money across different investments, extreme moves in one asset have less of an effect on your total portfolio, making your overall returns more consistent and predictable. Using the same sectors as above, healthcare and utilities are essentials that often experience steady demand and therefore lower volatility, while discretionary spending and technology can fluctuate more with trends and economic conditions, thus higher volatility. Mixing them together will lift the potential for higher returns while lowering the spikes in volatility.
Take advantage of compounding.
Depending on how you set up your portfolio — and when you rebalance it — compounding within a diversified portfolio can produce better results than the simple average return.
Let’s say you invest $100,000 into Portfolio A. Portfolio A includes two stocks, each stock returning 5% a year. That means Portfolio A averages 5% a year overall. An average 5% return over 10 years could turn your $100,000 into $325,779 — or $225,779 over your initial investment.
Now let’s say you invest $100,000 into Portfolio B, which also includes two stocks. Stock 1 returns 0% a year, while Stock 2% returns 10% a year. Portfolio B also averages 5% a year overall, but due to compounding, after 10 years your $100,000 could turn into $359,374 — or $33,595 more than Portfolio A.
Can you be too diversified?
Yes. Spreading your investments too thin can lead to a dilution of your returns. Experts suggest that beyond a range of about a dozen to three dozen assets, additional diversification provides little, if any, additional benefit. You could also lean too heavily on lower-quality assets, which can dilute your higher-quality assets, providing you with lower overall returns.
Taking into consideration that there are numerous ways to diversify and you can be too diversified, there’s no hard-and-fast rule for achieving a proper balance. So here are some signs that you’re probably in good shape.
1. You’ve got a sizable portion of your money in four or more different asset classes.
The most common portfolio allocations have at least 10% of your money invested in asset classes like cash or money market funds, stocks, bonds and property. Kudos if you also have money in commodities, like the popular gold, and alternative investments.
2. At any given time, at least one part of your portfolio is performing well.
Like a lunch buffet, a diversified portfolio offers something for everyone, no matter their appetite that day. Even if most investments are falling, a well-diversified portfolio will include a few rising investments.
3. You invest in exchange-traded funds.
Many ETFs provide instant diversification within a specific asset class or market sector. But you may need a few different ETFs to achieve a recommended diversification across all markets.
4. You aren’t fazed by daily volatility.
A well-diversified portfolio means you generally aren’t concerned about what the market does or what news is hyped on any particular day. If small market fluctuations are keeping you up at night, it could be a sign that you have too much money invested in one particular asset class.
5. You don’t listen to just one source for news, advice or ideas.
Risk and bias go hand in hand. Don’t settle for only conventional wisdom. Learn about other investment approaches, strategies and ideas, then find a balance that aligns with your financial goals and circumstances.
Disclaimer: The value of any investment can go up or down depending on news, trends and market conditions. We are not investment advisers, so do your own due diligence to understand the risks before you invest.
Diversifying your investment portfolio is an effective way to minimize the risk of losing money. But it’s not the only way to manage risk. For instance, you can be invested in the right assets but get the timing wrong.
Consider other risk management strategies as well — particularly when you plan to buy and sell — and review your overall investment plan periodically to adjust your assets. For an overview of the many aspects involved in buying assets and associated risks, read our comprehensive guide to investing.