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Diversification is the process of spreading your money across different investments, so that you don’t get too much exposure to just one investment. Diversification can increase your overall return without forcing you to sacrifice anything in return, providing what economists call a “free meal.” In other words, diversification can actually reduce risk without costing your returns.
Here’s how diversification works, why it’s so important, and how to diversify your portfolio.
What is diversification?
Diversification means owning a variety of assets that behave differently over time, but not too much of one investment or type. In terms of stocks, a diversified portfolio would contain 20 to 30 (or more) different stocks across many sectors. But a diversified portfolio can also contain other assets – bonds, funds, real estate, CDs and even savings accounts.
Each type of asset behaves differently as an economy grows and contracts, and each offers varying potential for gain and loss:
– Stocks offer the highest return potential over time, but can fluctuate wildly over shorter time periods.
-Bonds can offer more stable returns with a fixed payment, but can fluctuate as interest rates go up and down.
-Funds tend to be diversified because they usually hold many investments, but a specific fund may only hold one type, for example, consumer goods companies. Thus, a fund can be broadly or narrowly diversified, depending on how it is managed.
-Real estate can appreciate slowly over time and also offers income potential. But physical real estate can be expensive to maintain and the commissions are high.
-The value of CDs and savings accounts will not fluctuate but will increase regularly depending on the interest rate or other contractual conditions.
While some of these assets increase rapidly, others will remain stable or decline. Over time, favorites can become latecomers, or vice versa. In other words, these assets are not strongly correlated with each other, and this is the key to the attractiveness of diversification.
And it’s easier and cheaper than ever to make sure your portfolio includes a wide range of investments, zero commission at the major online brokerage firms.
How diversification benefits you
Diversification has several benefits for you as an investor, but one of the most important is that it can actually improve your potential returns and stabilize your results. By owning multiple assets with different performance, you reduce the overall risk of your portfolio, so no investment can hurt you. It is this “free lunch†that makes diversification such a compelling option for investors.
Since assets behave differently in different economic periods, diversification smoothes your returns. As stocks zigzag, bonds can crash and CDs keep growing steadily.
This is because by owning different amounts of each asset, you get a weighted average of the returns of those assets. While you won’t get the surprisingly high returns from owning just one rocket stock, you won’t experience its ups and downs either.
While diversification can reduce risk, it cannot eliminate all risk. Diversification reduces asset specific risk, i.e. the risk of owning too many stocks (like Amazon) or stocks in general (compared to other investments). However, this does not eliminate the market risk at all, which is the risk of owning this type of asset.
For example, diversification can limit the downside of your portfolio if certain stocks go down, but it can’t protect you if investors decide they don’t like stocks and punish the entire asset class.
For interest rate sensitive assets, like bonds, diversification helps protect you from a problem with a particular business, but it does not protect against the threat of a rate hike in general.
Even cash or investments such as CDs or a high yield savings account are threatened by inflation, although deposits are generally guaranteed from capital loss up to $ 250,000 per type of account. and by bank.
Diversification therefore works well for asset-specific risk, but is powerless in the face of market-specific risk.
How to develop a diversification strategy
With the advent of low-cost mutual funds and ETFs, building a well-diversified portfolio is actually straightforward. Not only are these funds cheap, but the big brokerages now allow you to trade a lot of them at no cost, so it’s extremely easy to get in the game.
A core diversified portfolio could be as simple as owning a broadly diversified index fund such as the one based on the Standard & Poor’s 500 Index, which has holdings in hundreds of companies. But you’ll also need some bond exposure to help stabilize the portfolio, and guaranteed CD returns will help as well. Finally, cash in a savings account can also give you stability as well as a source of emergency funds if you need them.
If you want to go beyond this basic approach, you can diversify your holdings into stocks and bonds. For example, you can add a fund that owns companies in emerging markets or international companies more generally, because an S&P 500 fund does not. Or you can go with a fund made up of smaller public companies, as that is outside of the S&P 500 as well.
For bonds, you can choose funds that have short-term bonds and medium-term bonds, to give you exposure to both and offer you a higher return on longer-term bonds. For CDs, you can create a CD ladder that gives you exposure to interest rates over a period of time.
Some financial advisers even suggest that clients consider adding commodities such as gold or silver to their portfolios to further diversify beyond traditional assets such as stocks and bonds.
Finally, no matter how you build your portfolio, you are looking for assets that react differently in different economic climates. It doesn’t create diversification if you have different funds that all have the same important stocks, as they will essentially perform the same over time.
And if that all seems like too much work, a fund or even a robo-advisor can do it for you. A target date fund will move your assets from higher yielding assets (stocks) to lower risk assets (bonds) over time, as you approach a target year into the future, typically the date of your retirement.
Likewise, a robo-advisor can structure a diversified portfolio to achieve a specific objective or target date. Either way, you’ll likely pay more than if you did it yourself, however.
At the end of the line
Diversification offers an easy way to smooth out your returns while potentially increasing them. And you can have a variety of models for diversifying your portfolio, from a core all-equity portfolio to a portfolio that holds assets across the risk and reward spectrum.
(Visit Bankrate online at bankrate.com.)
© 2021 Bankrate.com. Distributed by Tribune Content Agency, LLC.
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