What Is Diversification in Investing?
In finance and investing, diversification is a popular term for mitigating risk by dividing one’s investments between a variety of asset classes and investment vehicles. Diversification also refers to dividing one’s investments within each asset class.
For instance, In addition to diversifying their portfolio by investing in stocks, bonds, real estate, certificates of deposit, and collectible baseball cards, an investor could further diversify their portfolio within the stock asset class specifically by investing in small, mid, and large-cap companies; buying stock in both domestic and foreign companies; and choosing a variety of stocks that span many different industries (e.g., banking, technology, automotive, food production, and energy).
How Does Diversification Mitigate Risk?
No investment is perfectly safe, but some carry far less risk of loss than others. For instance, government bonds are considered extremely safe, as they carry very little default risk. That being said, government bonds usually only yield a 3–6% return each year. The S&P 500, which is composed of 500 large-cap stocks, on the other hand, returned 31.5% in 2019 and 18.4% in 2020. Back in 2008, however, the same stock index lost 48% of its value due to the financial crisis and subsequent recession.
If an investor put 100% of their savings in the stock market in early 2007, they may have reduced their wealth by almost half by the end of 2008. If they had invested half of their savings in government bonds, however, they would likely have lost closer to a quarter. This is a perfect illustration of the benefits of diversification. While diversification by no means provides the largest gains, it certainly helps minimize the losses that can occur when a single asset or single asset class loses value quickly for some reason or another.
The 2008 financial crisis crashed the entire stock market, but more minor events often have more subtle consequences. For instance, people travel far less frequently during pandemics. The onsets of SARS, swine flu, and COVID-19 all led to notable drops in airline stock prices. If at any of these moments in time, an investor was holding only airline stocks, their portfolio would have lost significant value quickly. An investor with a diversified portfolio, however (let’s say one composed of only 5% airline stocks with the rest divided across many industries), would have sustained a far less noticeable loss.
Diversification can perhaps be best explained with the classic adage, “don’t put all your eggs in one basket.” If the bottom falls out of your basket, and your basket contains all 10 of your eggs, you end up with a yolky mess and nothing to eat. If, on the other hand, you divide your 10 eggs between five baskets and the bottom falls out of one, you’ve lost 20% of what you had, but you still have enough leftover to make four two-egg omelets, so you won’t go hungry.
What Is an Asset Class?
An asset class is a type of investment defined by certain characteristics. Each asset class is a little different, and some are riskier than others. Generally, the safer an asset class is, the lower its potential returns are. The riskier an asset class is, the higher its potential returns (and losses) are. Each asset class is subject to its own unique set of features and regulations, and some assets are more liquid (easier to convert to cash) than others.
Common Asset Classes
- Fixed-Income Investments: This asset class includes treasury, corporate, and municipal bonds as well as certificates of deposit.
- Equities: This asset class includes stocks, which represent partial ownership of an entity. Historically, equities produce higher returns than other asset classes, but they also carry more risk.
- Derivatives: This asset class includes options, swaps, futures, forwards, and other tradable securities whose values are derived from other underlying assets.
- Commodities: This asset class includes physical materials like gold, crude oil, and corn.
- Cryptocurrencies: This asset class includes digital, decentralized currencies like Bitcoin, Ethereum, Litecoin, and Dogecoin.
- Cash and Cash Equivalents: This asset class includes currencies, money market instruments, and highly liquid short-term securities that could be converted to cash very quickly.
- Alternative Investments: This asset class includes real estate and collectibles such as trading cards, stamps, mineral specimens, and art.
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How to Diversify a Portfolio
Diversification looks different for every investor, and some take diversification a lot more seriously than others. How (and how much) an investor should diversify their portfolio should depend on how much money they have to invest, how long they want to be invested for, what their investment goals are (retirement, growth, fixed income payments, etc.), and their individual risk tolerance.
That being said, there are a number of things any risk-conscious investor can do to diversify their portfolio. Keep in mind, however, that while diversification definitely reduces risk, it can also reduce potential returns.
The best way to safeguard savings from serious loss without leaving them to languish in a low-interest savings account is to divide them among different asset classes. The equity (stock) market may be the best asset class for growth, but as evidenced by the 2007–2008 financial crisis, stocks can be subject to rapid, unexpected, market-wide devaluation.
For this reason, investing in treasury bonds, certificates of deposit, real estate, and even commodities like gold can be a good way to safeguard some of one’s wealth from unexpected volatility. Just how much of someone’s wealth should be kept in these safer, more stable asset classes depends—as always—on goals, timeline, and risk tolerance.
A young, risk-tolerant investor who wants to see their portfolio grow significantly in value and plans to stay invested for 20+ years might want to keep 80 percent of their wealth in equities, while an older, soon-to-be-retired investor whose priorities are stability and fixed income payments might want to keep 50 percent of their wealth in dividend-paying equities, 35 percent in bonds of various terms, and 15 percent in commodities.
Diversification Methods Within the Stock Market
In addition to diversifying by spreading wealth between asset classes, investors can (and usually should) diversity within the equity market by owning different stocks with different characteristics. There are a number of ways to do this:
- By Industry/Sector: As mentioned above, investing in only one industry can expose an investor to unnecessary risk, as entire industries can experience volatility. For instance, when the “dot com” bubble burst in the early 2000s, internet-related technology companies lost almost 80 percent of their value. By holding stocks across a variety of industries and sectors, investors can protect some of their wealth from these sorts of industry-wide crashes.
- By Company Size: Another way to diversify within the equity market is by investing in companies of different sizes. Companies with larger market caps tend to be more stable, but companies with smaller market caps may have more room for growth. Spreading investments across small, mid, and large-cap stocks is a good way to balance growth potential with stable returns.
- By Company Location: Investing in companies from a number of different countries allows for exposure to multiple markets, which can help mitigate risk. If one market experiences volatility, owning businesses that operate in other, more currently stable markets can help offset any short-term losses.
How to Diversify With Mutual Funds and ETFs
For more passive investors who want to diversify but don’t have the time to pick individual stocks, buying ETF shares and investing in mutual funds can be a great way to gain exposure to companies of various sizes from a variety of industries located in different markets. ETFs and mutual funds exist for almost every characteristic imaginable. One ETF might focus on small-cap U.S. growth stocks, while another might be designed to capture the Indian energy market.
An investor might first decide what markets, company sizes, and industries they are interested in, then identify a range of ETFs and mutual funds to match. Next, they could decide on a reasonable amount to invest each month and use dollar-cost averaging to add to their portfolio on a regular basis without watching the market particularly closely.
Do Diverse Portfolios Perform Better During Recessions?
During a recession, money tends to move out of the equity market and into safer asset classes like bonds and commodities. For this reason, portfolios with a higher proportion of these more stable assets are likely to sustain smaller losses than portfolios consisting primarily of stocks. That being said, it is impossible to time a recession, and keeping all of one’s money out of the equity market in case a recession is around the corner isn’t a very good investment strategy for anyone seeking to grow their wealth efficiently.
What Are the Limitations of Diversification?
What makes diversification effective as a risk-management strategy can also make it somewhat limiting in terms of growth potential. With greater risk come greater potential returns. The more of an investor’s money is in one asset, the more they stand to gain if that asset skyrockets in value (and, on the other hand, the more they stand to lose if it tanks). Diversification limits both gains and losses.