What is diversification?
Diversification is a common investment strategy through which investors spread their portfolio across different types of securities and asset classes to reduce the risk of market volatility. It’s part of what’s called asset allocation, meaning how much of a portfolio is invested in various asset classes. Three of the most common asset classes include stocks, bonds and cash (or cash equivalents). To achieve diversification, investors will blend dissimilar assets together so that their portfolio does not have too much exposure to one individual asset class or market sector.
Investors have many investment options, each with its own advantages and disadvantages. Some of the most common ways to diversify your portfolio include diversification by asset class, within asset classes and beyond asset class.
Say you invested all of your money only in Apple stock (AAPL). Apple is a technology company, so this would mean that your asset allocation would be 100% equity (or stock) all in the technology sector of the market. This is a risky approach because if Apple stock prices were to slump due to unforeseen circumstances, your whole investment portfolio would suffer the consequences. You might diversify within the technology sector by investing in other tech companies, but if the whole technology sector is negatively impacted, your portfolio would still take a big hit.
To appropriately diversify a portfolio, you’ll need to include stocks from many different sectors. Even still, you may also want to include bonds or other fixed income securities to protect against a dip in the stock market as a whole.
Diversification is the simplest way to boost your investment returns while reducing risk. By choosing not to put all of your eggs in one basket, you protect your portfolio from market volatility. Diversification may look a little different for each investor. Factors such as time horizon and risk tolerance should be assessed on a case-by-case basis to determine how to best construct each portfolio to fit the individual needs of each investor. Luckily, there are plenty of tools available that help make it easy to diversify your investment accounts.
Diversification by asset class
The three main general asset classes in an investment portfolio are stocks, bonds and cash.
- Stocks (or equities) allow investors to own a piece of a company. Stocks offer the highest long-term gains but are volatile, especially in a cooling economy.
- Bonds (or fixed income) pay interest to investors who lend money to a company or government. Bonds are income generators with modest returns but are usually weaker during an expanding economy. Generally, bonds have an inverse relationship with stocks.
- Cash (or cash equivalents) is the money in your savings account, pocket or hidden under your pillow. In terms of risk and return, cash is low on both counts. Cash can buffer volatility or unexpected expenses and acts as “dry gunpowder” to invest during opportune times.
There are other asset classes such as real estate (property), commodities (natural resources, precious metals) and alternative investments. These asset classes usually have lower correlation to the stock market and as such can be effective to aid in diversification.
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Diversification within asset classes
After asset level diversification, investors can further the process by categorizing the main general asset classes into sub-classes or breaking them down into more detail.https://embeds.nerdwallet.com/table/?table_id=8252&nwaMode=embed
Diversification beyond asset class
Diversification can extend beyond traditional asset classes found in typical investment accounts. Investment accounts have non-guaranteed returns since they are subject to market fluctuation. However, there are other product types such as pensions, annuities and insurance products that can provide guaranteed income streams and returns. For reduced risk, investors often diversify their portfolio by spreading their investment dollars among these different product types as well.
Why is diversification important?
Diversification provides what professionals call a “free lunch” — reducing overall risk while increasing the potential for overall return. That’s because some assets will perform well while others do poorly. But next year their positions could be reversed, with the former laggards becoming the new winners. Regardless of which stocks are the winners, a well-diversified stock portfolio tends to earn the market’s average long-term historic return. However, over short-term periods that return can vary widely.
Below, the graphic from J.P. Morgan shows the variability of different types of investments from 2004 to 2018. Navigating the market’s fickle nature, the “asset allocation portfolio” (a diversified portfolio with a mix of investments) stays in the middle of the pack, achieving an annualized return of 6.2% over the time period and evening out the ride