Portfolio Diversification: What It Is and Why It’s Important

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portfolio diversification - Portfolio Diversification: What It Is and Why It’s Important

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Diversification is the strategy of spreading your money out across various investments and sectors to reduce risk. By diversifying your funds, you’re less likely to lose a large amount of funds if one investment performs poorly. Learn how diversifying your investments can maximize your returns, and how to create a well-balanced portfolio.

What Does Diversification Mean in Investing?

Diversification is the investing strategy of spreading your money out across different asset classes, such as stocks and bonds. Allocating your funds across different investments mitigates your portfolio’s risk, since if one area of your portfolio plummets, others are likely to stay steady or even grow in value. Diversifying is a way to avoid “putting all your eggs in one basket.”

Diversifying also means buying different investments within a certain asset class. For example, within your stock portfolio, you may want to buy stocks of large and small companies, domestic and international companies, and those in various sectors, like technology and industrials.

Fast Fact
Stock and bond prices typically don’t move up and down at the same time, making them strong investments to pair for diversification. 
Source: U.S. Securities and Exchange Commission

Diversification Example

Let’s say Bruce is looking to invest in stocks and bonds.

To get a broad mix of bonds, he may want to consider bonds from the three different types of issuers: the federal government, local governments and corporations. Each of these types of bonds have different pros and cons to consider. Corporate bonds, for example, usually pay higher yields while interest from municipal bonds — those issued by local governments — is generally exempt from federal income taxes.

Bruce would also want to consider buying bonds with different maturity dates. He may want to invest in some bonds with short-term maturities, like one to three years, in addition to those with long-term maturities of more than 10 years, depending on his specific investment goals and time horizon.

As for stocks, Bruce will likely want to invest in stocks of various industry sectors such as healthcare, information technology and real estate. That way, if one sector performs poorly, the others may be able to  mitigate the loss. He’ll also want to consider buying stocks of companies of various sizes, as well as both domestic and international stocks.

Your diversification should align with your investing goals, risk tolerance and time horizon. It’s a good idea to speak with a licensed financial advisor to help you determine how to best allocate your funds.

Advisors will often recommend buying broad funds, like exchange-traded funds (ETFs) and mutual funds, instead of picking and choosing individual stocks. There are also other investment and savings vehicles to consider, such as real estate and certificates of deposit.

3 Tips for Diversifying Your Portfolio

Choosing your investments without considering diversification will likely hurt your portfolio in the long run. These three tips can help you build and maintain a well-balanced portfolio.

  1. Rebalance your portfolio regularly.
    • As the financial markets move, so do the values of your investments. Rebalancing is a strategy that entails buying and selling investments to get your portfolio back to its initial ration. The Financial Industry Regulatory Authority (FINRA) suggests rebalancing your portfolio at least once a year.
  2. Consider long- and short-term investments.
    • Having short- and long-term investments, like bonds with varying maturity dates, helps diversify your portfolio as well. Generally, financial advisors recommend investing in stocks for the long term.
  3. Don’t only invest in what you know.
    • While it may be tempting to only buy stocks of large companies that you are familiar with, like Starbucks and Target, it’s important to consider investments of various sizes and sectors.

Sources:

Howard, C. (2023, July 25). Municipal vs. Corporate Bonds: How to Choose. Retrieved from https://www.schwab.com/learn/story/municipal-vs-corporate-bonds-how-to-choose

Harvard Business School. (2021, September 28). How To Diversify Your Portfolio With Alternative Investments. Retrieved from https://online.hbs.edu/blog/post/how-to-diversify-your-portfolio

FINRA. (n.d.). Asset Allocation and Diversification. Retrieved from https://www.finra.org/investors/investing/investing-basics/asset-allocation-diversification

U.S. Securities and Exchange Commission. (n.d.). Asset Allocation. Retrieved from https://www.investor.gov/introduction-investing/getting-started/asset-allocation