This concept is known as diversification.
What Is Diversification?
Diversification means spreading your investments across different assets, companies, industries, regions, or other categories.
The purpose is to reduce the impact that any single investment can have on your overall portfolio.
For example, if an investor owns shares in only one company and that company experiences serious problems, the investor could suffer a major loss. If the investor instead owns a diversified portfolio containing many companies and other assets, the effect of one company’s decline may be smaller.
Diversification cannot guarantee profits or eliminate losses, but it can help manage certain types of investment risk.
Start With Your Goals
Before choosing investments, determine your financial goals.
A portfolio designed for retirement decades away may look very different from one designed to fund a purchase in three years.
Ask yourself:
- What am I investing for?
- When will I need the money?
- How much can I regularly invest?
- How much loss could I financially and emotionally tolerate?
- Do I need income from my investments?
These questions can help establish an appropriate strategy.
Understand Asset Allocation
Asset allocation refers to how your portfolio is divided among different asset classes.
Common asset classes include stocks, bonds, cash, and certain other investments.
Stocks generally offer greater growth potential but can experience significant short-term declines. Bonds may provide income and diversification but also carry risks such as interest-rate and credit risk. Cash is generally more stable in nominal value but may lose purchasing power over time because of inflation.
The right combination depends on your individual circumstances.
Diversify Within Asset Classes
Diversification is not simply about owning several investments.
Suppose you own ten technology companies. You have ten investments, but your portfolio is still heavily concentrated in one sector.
A more diversified approach could include companies from different industries, market segments, and geographic regions.
Funds can make this easier because a single fund may contain many securities.
Consider Geographic Diversification
Investors should also consider where their investments are located.
Owning investments from multiple countries or regions can reduce dependence on the economic performance of a single country.
However, international investing introduces additional considerations, including currency movements, political risks, different regulations, and economic conditions.
Therefore, geographic diversification should be considered as part of a broader investment strategy.
Rebalancing Your Portfolio
Over time, investments will perform differently.
Imagine a portfolio that starts with 60% stocks and 40% bonds. If stocks perform particularly well, the portfolio might eventually become 70% stocks and 30% bonds.
This changes the portfolio’s risk profile.
Rebalancing involves adjusting investments to bring the portfolio closer to its intended allocation.
Some investors rebalance on a schedule, while others do so when allocations move beyond predetermined ranges.
Avoid Over-Diversification
Diversification is useful, but more investments do not automatically mean a better portfolio.
Owning dozens of overlapping funds may make your portfolio more complicated without providing meaningful additional diversification.
The goal should be effective diversification rather than simply accumulating investments.
Understand what each fund or investment owns and look for significant overlap.
Think About Costs
A diversified portfolio should also be cost-conscious.
Every fee reduces the amount of money that remains invested.
When comparing funds or investment platforms, examine expense ratios, commissions, advisory fees, and other charges.
Lower costs do not automatically make an investment better, but unnecessary costs can be a disadvantage over long periods.
Keep Your Strategy Simple
Many investors make portfolios more complicated than necessary.
You do not need to own every possible investment category.
A simple, diversified portfolio that you understand may be easier to maintain than a complicated portfolio filled with investments you do not fully understand.
Simplicity can also make it easier to remain disciplined during periods of market volatility.
Review Your Portfolio Periodically
You do not need to check your investments every hour.
In fact, constantly watching prices can encourage emotional decisions.
Instead, review your portfolio periodically to make sure it still matches your goals, risk tolerance, and financial circumstances.
Life changes can also require adjustments. A new job, marriage, major purchase, change in income, or approaching retirement may affect your investment strategy.
Final Thoughts
Diversification is one of the most important concepts for investors to understand. By spreading investments across appropriate asset classes, companies, sectors, and regions, investors can reduce their dependence on any single investment.
However, diversification should not be viewed as a guarantee against losses. All investments involve some level of risk.
The goal is to create a portfolio that matches your objectives, time horizon, and ability to tolerate risk.
A good portfolio does not need to be complicated. It needs to be intentional, diversified appropriately, reasonably cost-efficient, and aligned with your long-term financial plan.
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