What is diversification & how does it work?
October 12, 2023 7 min read
One of the essential components of successful investing involves a concept called diversification. It aims to boost investment returns and reduce investment risks by spreading assets across different kinds of investments, different industries and different regions.
Read along to learn more about the benefits of investment diversification.
- Portfolio diversification can help an investor reduce risk and safeguard against market volatility.
- An investor can take several approaches to diversification, such as investing beyond just one asset type, like stocks, and buying assets with different levels of risk.
- Mutual funds and exchange-traded funds, or ETFs, are among the investment vehicles that may make it easier to diversify a portfolio.
What is diversification in investing?
Diversification can help shield an investor from risk. By putting money into different types of investments and different industries, an investor hopes to offset losses from one investment with gains from another investment.
Gains from lower-risk bonds in a portfolio might counterbalance losses from higher-risk tech stocks, for instance. Also, diversification can keep an investor from relying only on one investment category.
Types of investment diversification strategies
Investment diversification strategies come in several forms. Among the types of investment diversification strategies are:
- Establishing correlation. Correlation measures how the ups and downs of asset values compare across the market or within a portfolio. For instance, stocks historically have a low correlation with bonds, as the two tend to move in different directions. Therefore, stocks and bonds can be complementary investments.
- Diversifying across asset classes. Among the asset classes that an investor might consider for a diversified portfolio are stocks and real estate. Investing in different asset classes can help reduce risk and improve returns.
- Diversifying within asset classes. Diversifying within asset classes can help an investor dodge risk and post healthier returns. To diversify within an asset class, an investor might choose a dozen individual stocks from an array of industries or buy shares of a mutual fund or exchange-traded fund (ETF). Mutual funds and ETFs pool investors’ money and purchase assets like stocks and bonds or purchase a mix of asset types.
- Diversifying by geography. Adopting a location diversification strategy results in buying investments in different regions, such as North America and Asia, and in different countries.
- Looking at alternative investments. Stocks and bonds are two of the traditional types of investments. Alternative investments include real estate, private-company stocks and collectibles like wine and artwork. Alternative investments might present more risk than traditional investments but also might deliver bigger returns.
- Rebalancing your portfolio. When an investor rebalances their portfolio, they are adjusting the weight carried by different asset classes. To rebalance a portfolio, an investor buys and sells chunks of their holdings to, say, put more emphasis on stocks and less emphasis on bonds. Experts say rebalancing should be done regularly to account for fluctuations in the performance of an asset type and steer away from investment losses.
- Weighing your tolerance for risk. When you evaluate your risk tolerance, you are figuring out how much of a drop in investment value you are willing to swallow. This determination might lead to investing mostly in lower-risk, lower-return assets or higher-risk, higher-return assets.
Diversification by asset class
Diversifying by asset class can help bring stability to an investment portfolio. Here are some examples:
- Stocks within one asset class: Diversification within the asset class of stocks may mean buying shares in a dozen companies rather than just a couple of companies.
- Bonds within one asset class: Diversification within the asset class of bonds could result in buying bonds from different types of issuers, such as governments and corporations, as well as bonds with different credit ratings and different payout periods.
- Mutual funds and ETFs: To make investments in several asset classes, an investor might look at buying shares of a bond mutual fund and a stock-based ETF. This could enable an investor to get exposure to more than one asset class without handpicking individual stocks and bonds.
- Traditional investments and alternative assets: An investor might choose to assemble a portfolio with a combination of traditional investments like stocks and bonds and alternative assets like real estate and collectibles.
Diversification by industry or market sector
Investors also can diversify their portfolios based on industry or market sector. On an industry basis, they might prioritize stocks in airlines, banks, electric companies and aerospace companies, for example. More broadly, they may concentrate on stocks in industries like communication, health care and energy.
Diversification by corporate life cycle
Corporate life cycles represent the stages of business growth: development, launch, growth, maturity and decline or renewal. An investor might be able to diversify their portfolio by investing in an early-stage startup, an established company and a rebounding company, for example. These life cycles represent various levels of risk.
Diversification by market size
Another diversification strategy involves choosing investments by market size—namely small-cap, mid-cap and large-cap companies. “Cap” refers to a company’s market capitalization, or the value of its outstanding shares of stock. Here are the values generally assigned to small-, mid- and large-cap companies:
- Small cap: Market value between $250 million and $2 billion
- Mid cap: Market value between $2 billion and $10 billion
- Large cap: Market value between $10 billion and $200 billion
Diversification by risk level
An investor might decide to build their portfolio, in part, by including assets with different levels of risk. For example, they might balance potentially lower-risk, lower-return bonds with potentially higher-risk, higher-return stocks in companies whose shares have just started trading publicly.
Diversification through exchange-traded funds (ETFs)
An investor can buy shares of an ETF just as they can buy shares of a publicly traded company. Essentially, an ETF is a basket of stocks, bonds or other assets. For example, an ETF might own stocks tied to a market index such as the S&P 500 or Dow Jones Industrial Average or stocks in a particular industry like energy or utilities.
Diversification through mutual funds
A mutual fund is another option for portfolio diversification. Much like an ETF, a mutual fund pools money from many investors to buy stocks, bonds, short-term debt or other assets. Mutual fund investments cover an array of companies and industries. An investor purchases shares in a mutual fund directly from the fund or through an investment brokerage.
Diversification through alternative investments
Rather than relying solely on traditional investments such as stocks and bonds, some investors opt to add generally higher-risk alternative investments to their portfolios. Alternative investments include real estate, artwork, wine, farmland, cryptocurrency and gold. Aside from the risks they carry, alternative investments generally are not heavily regulated.
Potential diversification benefits
Potential benefits of diversification include:
- Lower risk: Diversification holds the potential to decrease investment risk due to the balance of assets.
- Less volatility: A diversified portfolio can help an investor make it through swings in the market.
- Higher returns: Over the long term, portfolio diversification might deliver bigger investment returns thanks to a more balanced approach to risk.
Potential diversification downsides
Potential downsides of diversification include:
- Lower returns: Over time, diversification might supply lower returns, especially in the short term, if a portfolio is weighted more toward lower-risk than higher-risk investments.
- Investor confusion: An investor may feel overwhelmed by managing and tracking a bunch of different investments.
- Additional fees: Buying a broad range of investments may trigger investment fees. For instance, mutual funds typically charge an annual management fee.
Here are answers to three common questions about portfolio diversification:
Why is portfolio diversification important?
Portfolio diversification can help an investor manage risk and weather market volatility. Ultimately, diversification may offer better investment returns.
What’s the difference between asset allocation and diversification?
Normally based on percentages, asset allocation involves determining the mix of assets in your portfolio. For example, you might decide to invest 60% in stocks and 40% in bonds. On the other hand, diversification means spreading around the assets, such as buying stocks in various industries or from various parts of the world.
Diversification in a nutshell
At its core, portfolio diversification can help ensure you have enough money set aside to realize your financial goals, such as early retirement. Of course, diversification comes with risks and rewards. The rewards include potentially lower investment risk and higher investment returns, while the risks include possibly lower investment returns and higher investment fees.
Now that you are educated about the ins and outs of portfolio diversification, learn ways to prepare for economic uncertainty.