Key takeaways
Investment diversification is a long-term strategy that may help reduce risk from market volatility.
A diversified portfolio should include a mix of asset classes, diversification within asset classes, and adding foreign assets to your investment strategy.
Working with a financial professional can help you avoid diversification pitfalls such as over-diversification and not taking correlation into account.
Diversifying your portfolio is a financial strategy that aims to reduce your portfolio risk by varying the type of assets you invest in, knowing they will perform differently over time. Ensuring you have a diversified portfolio can help reduce your risk exposure and help you feel better prepared for the future. But what exactly constitutes diversification? And how do you properly diversify your assets? Answering these questions can help you stay on track to meet your investment goals.
What is a diversified portfolio?
A diversified investment portfolio is built with a variety of investments that have low correlation, with a different pattern of expected risks and returns (also known as diversification).As a key part of risk management, investment diversification is a long-term strategy to help safeguard against market volatility and ensure you see the greatest return on your investments.
Benefits of a diversified portfolio
The largest benefit of a diversified portfolio is that it can help minimize risk from market volatility. As an example, both stocks and bonds are subject to market fluctuations. By having a mix of each, you may offset potential downturns when one isn’t performing as well as the other.
Diversification is also a way to safeguard against industry-specific risks. Let’s say the price of oil falls—it’s possible that multiple businesses in the energy sector will see their prices fall, too. If you’ve invested in industries that use energy, that price drop should reduce their costs and support their earnings, which will soften the impact to your portfolio compared to just owning energy stocks.
Because diversification allows you to essentially “smooth out” your risk and remain less vulnerable to volatility, you have the potential to see greater returns in the long-run.
How to build a diversified portfolio
So how do you create a well-balanced and diverse portfolio? There are many different diversification strategies, but here are some key points to consider:
- Diversify across asset classes. Having a mixture of equities (stocks), fixed income investments (bonds), cash and cash equivalents, and real assets including property can help you maintain a well-balanced portfolio. Generally, it’s wise to include at least two different asset classes if you want a diversified portfolio.
- Diversify within asset classes. There are a few key ways to diversify within each asset class, including by industry. Using the example above about energy stocks, if that field is something you’d like to invest in, consider other ways you might diversify your investments among industries such as technology, healthcare, or utilities. You can also diversify your fixed income investments by seeking out bonds with different maturities and from different issuers.
- Invest globally. Consider global exposure when building your portfolio to safeguard against country-specific risks. Foreign assets like stocks and bonds for companies in other countries can help you create a more well-rounded, diverse portfolio that still performs well at times when the U.S. market may be struggling.
- Perform a regular portfolio review. In any given year, certain investments will gain value while others may decrease. You should rebalance your portfolio regularly to ensure you’re staying the course amid inevitable market highs and lows—and certain situations like major life events will trigger the need to rebalance, too.
Portfolio diversification mistakes to avoid
While building a diversified portfolio may sound intuitive, it involves careful planning to ensure you still maximize your returns while minimizing your risk. Here are two of the most common investing mistakes to avoid:
- Over-diversification. Unfortunately, it’s possible to over-diversify your portfolio. This can lead to many positions that water down potential returns, making it hard to manage your portfolio. Working with a financial professional can help ensure you have the right balance of assets in place to generate the best returns possible.
- Not paying attention to correlation. Some asset types typically trend up or down together. This means that even with different asset types in your portfolio, if they all correlate with one another, your portfolio won’t be adequately diversified. For example, high-yield bonds often positively correlate with stocks; meaning if your portfolio is entirely made up of high-yield bonds and stocks, it won’t be well-diversified.
With some proper planning, diversifying your portfolio may help you minimize risk and maximize your returns, bringing you one step closer to your financial goals. Work with a financial professional to ensure you’re on the right track with your investments and are taking a diversified approach.
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