What is Portfolio Diversification?
Portfolio diversification refers to investing in a variety of assets, in order to balance risk and reward.
April 4, 2022
This article is provided for informational purposes only and should not be construed as legal or investment advice. Always consult with a professional financial or investment advisor before making investment decisions.
Investing is vital for building wealth and achieving financial security.
For beginners, building an investment portfolio can feel complex. There are so many different assets to invest in, and we often hear experts recommend diversifying our investments.
But what does diversification mean?
What is portfolio diversification?
Diversification is the practice of investing in multiple different assets to limit your exposure to any one asset or asset class.
Portfolio diversification usually involves investing in a variety of stocks, bonds, ETFs/mutual funds and more. Your “portfolio” is a term used to describe all the assets you have invested in.
Diversification helps investors balance risk and reward. By investing in an array of assets, investors can benefit from solid returns while reducing the risk of a single investment derailing the entire portfolio.
The opposite of diversification is portfolio concentration. If your portfolio is too concentrated on any one asset, you could be taking on more risk than you need to.
For example, investing 100% of your assets in a single company’s stock is highly risky. If that company goes bankrupt, you could lose 100% of your money. Likewise, investing 100% in real estate would be highly risky.
A better approach would be to meet in the middle. Building a balanced portfolio with many assets, geographical exposures, company sizes, etc., can help protect you from volatility and reduce the overall risk of your portfolio.
“Don’t put all your eggs in one basket”
We’ve all heard this classic saying. The point is simple: If all your “eggs” are in one basket, and you drop the basket, all your eggs could break. If you spread out your eggs in many baskets instead, your risk is more limited.
The same principle applies to your investments. Diversification is a key component of investment planning, and it should be a top priority for investors of all experience levels.
Elements of portfolio diversification
Building a balanced, diversified portfolio involves more than just investing in different types of stocks. Ideally, you want to be truly diversified, which might mean investing in:
U.S. stock market index funds
International stock market index funds
Large, medium and small company stocks
Bonds or bond funds
Real estate or REITs
You might consider including a small number of alternative assets in your portfolio. This could include cryptocurrency, gold or even something like artwork.
Even within a certain asset class, you can further diversify. For instance, you could buy a small-cap index fund in addition to your standard investments. This would give you more exposure to smaller, publicly traded companies.
Most common investment asset classes
Need a refresher on the common asset classes?
Stocks are the core of most investor portfolios. When you buy a stock, you are buying a small percentage of the company. The term “stocks” can refer to individual stocks (like Microsoft or Amazon), or stock funds (an S&P 500 index fund or a stock-based mutual fund).
ETFs & mutual funds
ETFs(exchange-traded funds) and mutual funds provide a way to invest in many stocks all at once. Instead of buying an individual company, you can buy hundreds. For example, an S&P 500 index fund includes stocks from 500+ of the largest publicly traded companies in America.
International stocks are stocks in companies outside of the United States. International ETFs and mutual funds are also available.
When you buy a bond, you’re buying a promise that you’ll be paid back after a certain period — and you’ll earn interest along the way. Both individual bonds and bond funds are available.
Real estate investments include physical property or an investment product like a real estate investment trust (REIT).
Cryptocurrency is a type of digital currency. The most popular include Ethereum (ETH) and Bitcoin (BTC).
Other assets could include precious metals (gold and silver), commodities, artwork, collectibles and so on.
Approaches to a diversification strategy
There’s no one-size-fits-all approach to portfolio diversification. Below are some common portfolio diversification strategies that investors use.
Do-it-yourself diversification is a common strategy. It simply involves manually investing in a variety of assets and aiming to build a diversified portfolio.
While the DIY approach is common, it’s not necessarily the best option. Many people may think that they are more diversified than they actually are.
Want a simple DIY diversification strategy? Try out a simple three-fund portfolio.
Asset allocation funds
Asset allocation funds take the guesswork out of diversified investing. These are single funds that invest in a variety of assets, usually using broad index funds. Many are separated into broad categories, like:
Conservative funds hold more fixed income (bonds) than stocks. For example, 70% bonds, 30% stocks.
Balanced funds hold similar amounts of fixed income and stocks. For example, 50%/50%, or 60% stocks, 40% bonds.
Aggressive funds hold mostly stocks with a small amount of fixed income. For example, 90% stocks and 10% bonds.
Asset allocation funds provide a single fund with diversification built in. Just be sure to keep an eye on investment fees with these funds — you should aim to keep fees as low as possible.
Target date funds
Target date funds are single funds that are optimized for retirement at a certain date and are a simple method to diversify retirement savings.
The assets these funds invest in change over time, becoming more conservative as you approach retirement age.
A 2050 target-date fund is designed for people who plan to retire around 2050.
For example, consider VFIFX, a 2050 target-date retirement fund. The fund uses broad index funds, with both domestic and international stocks, and U.S. and domestic bond funds.
This fund is currently invested roughly 90% in stocks, and 10% in bonds. The fund will automatically shift more toward bonds as we get closer to 2050.
Target-date funds are a simple, “set it and forget it” strategy for a diversified retirement portfolio.
Robo-advisors are high-tech investment companies that help automate investing strategies.
Often, these platforms will ask investors a series of questions when they sign up. The questions involve financial goals, investment experience, risk tolerance and more.
From there, the platform will recommend a ready-made portfolio for your situation. In most cases, the portfolio will consist of several index funds and ETFs.
Many robo-advisors can automatically rebalance portfolios, as well. This means that if you have an 80% stocks/20% bonds portfolio and the stocks grow to 82%, the robo-advisor may automatically sell some stocks to buy more bonds.
Debt & investing
Investing for the future is important, but paying off debt might be more vital, in many cases.
Debt is the opposite of an investment. Investing grows your wealth; debt shrinks it.
If you have high-interest debt, paying it off should be a top financial priority. A great way to tackle credit card debt is to use Tally.† Tally helps qualifying Americans manage credit card debt and pay off their debts faster while saving on interest.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. Based on your credit history, the APR (which is the same as your interest rate) will be between 7.90% - 29.99% per year. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 - $300.