What Is Diversification in Investing? (2024)

Think of a diversified portfolio as a garden: A flourishing garden has a mix of different plants that offer unique benefits. Some bloom best in sun, some in shade. Some bloom early in the season, some later in the season. Some are more drought tolerant. By including a mix of plants, you’ll likely always have something in bloom. When certain plants aren’t doing well, others may be doing just fine.

Like a garden, a diversified financial portfolio assumes that not every asset is going to be performing well at the same time. But when some assets struggle, other assets perform well and generally keep everything in balance. Here, we’ll explain what a diversified portfolio is, what it looks like, and why it is so important to a successful investment strategy.

Diversification

Diversification means spreading your investments across multiple asset classes, sectors and investing styles. Putting all your investment dollars into a single stock or sector of the economy could result in large gains in the short term. But over the long term it’s not likely to yield the best results. History shows that it’s better to build a portfolio that includes a variety of asset classes. That’s diversification in a nutshell.

Let’s take a closer look at how diversification works in investing.

Diversifying investments

Let’s start with investments. Most investors strive to spread their investment dollars among stocks and bonds (both often through mutual funds) to achieve the best mix or "asset allocation"for their risk tolerance and time frame. A diversified portfolio will expand to include a varying proportion of different types of stocks (large and small cap, U.S. and international), bonds, cash equivalents, commodities and more.

This is ideal for most investors because asset classes may behave differently depending on the economic backdrop, sentiment in markets, Federal Reserve policy, geopolitical events and more. High-quality bonds, for example, tend to perform better when stocks are on the ropes. Commodities (raw materials, which are either consumed directly or used to make more complex products) can help investors keep pace with inflation, as material costs are often a source of inflation.

Essentially, diversifying a portfolio is an important way to manage risk in an unpredictable world. For every expected outcome, the world throws us surprises. Who saw COVID and its ensuing economic impact coming? Russia’s invasion of Ukraine exacerbated increasing prices for commodities in ways few would have predicted a year earlier. What’s true today is rarely true a year from now, much less 10 years from now. Times change, and so do leading asset classes. With strategic diversification, you’ll already be in position to capture some increased value, or “upside,” when the world changes and sentiment shifts.

The trick is to determine an asset allocation that balances risk and reward in a way that’s appropriate for your investing timeline and tolerance for risk. A Northwestern Mutual financial advisor can work with you to learn about what you want to accomplish financially, and based on that knowledge he or she can help you build a plan designed to take the appropriate amount of risk to get you to your goals.

What is a diversified portfolio example?

Diversification typically starts with an allocation to riskier and safer assets that is based on your unique situation (your risk tolerance). In the most basic sense, this is usually a target percentage of stocks and bonds—perhaps 80 percent stocks and 20 percent bonds for someone who has a higher risk tolerance. For those with a lower risk tolerance, the mix might be closer to 40 percent stocks and 60 percent bonds. In the latter example, if the stock market is doing well, 40 percent of your investments will grow. But if stocks are performing poorly, bonds should perform well.

Techniques for diversification

Beyond simply allocating to stocks and bonds, a well-diversified portfolio includes thinking within and across asset classes. For stocks, that might mean strategically buying large, medium and small companies as well as companies located in different parts of the world. With bonds, you might buy different types of bonds (U.S. government, municipal and corporate) and bonds that last for different lengths of time. Remember, the goal is to spread out your risk of loss while positioning yourself to take advantage of the upside when one particular investment group performs well.

A financial advisor can help make sure you are diversified across asset classes. When you work with Northwestern Mutual, we'll make sure you’re properly diversified within your investment portfolio. But we’ll also look at your financial picture broadly. We recommend financial tools beyond just investments to make sure that you’re not only positioned to grow your wealth but also protected if life takes an unexpected turn. Our advisors are trained to coordinate your investment approach with additional financial tools, helping you achieve better outcomes over time.

Other financial products work differently when it comes to income taxes. For example, when you contribute to a Roth IRA or Roth 401(k), income taxes have already been taken out. The money will grow tax-free and typically won’t be considered taxable income in retirement. Having money stashed away in accounts with different tax treatments can give you flexibility to manage your tax bracket in retirement. That can help your savings go further in retirement tomorrow while also getting you tax benefits today.

Diversifying risk exposure

Different investments come with different types of risk, and by diversifying your investments, you can help diversify the type of risk you’re taking—which ultimately reduces the overall risk you take on. Some investment risks you may want to be aware of are:

• Market risk: This is the concern that the price of stocks, bonds, commodities and other common investments will move day to day—or even minute to minute.
• Interest rate risk: This is the concern over the impact that a change in interest rate has on your portfolio, especially bonds. As interest rates rise, the value of bonds decrease, and yield increases.
• Credit risk: Also called “default risk,” this is the possibility that a borrower might not be able to meet its lending obligations and repay debt.
• Inflation risk: The possibility that your returns will not keep up with the rate of inflation, which could translate into a loss of purchasing power over time, can be a major concern with more conservative investments like cash, cash equivalents and even bonds, which tend to provide lower total returns over time than assets like stocks.
• Liquidity risk: This is a measure of how readily you can convert your assets into cash at a fair price. In general, cash, cash equivalents, stocks and bonds are all considered to be relatively liquid assets because there is a well-established market for buying and selling them. “Hard” assets like real estate and collectibles (among others) are often considered to be less liquid (and thus have a higher liquidity risk) because it’s not always easy to quickly convert their value to cash.
• Currency risk: If you hold foreign investments, the performance of those investments will depend in part on the exchange rate between currencies. If an exchange rate were to move rapidly in one direction or another, it could have a major impact on investments you have in that country.
• Political risk: Also referred to as “regulatory risk,” this refers to the likelihood that an investment’s performance might be influenced by political developments. This can include political instability, unexpected regime changes, unexpected election results, military activities, and the introduction of new laws and regulations.

Having a diversified portfolio isn’t always easy

Building a diversified portfolio isn’t necessarily difficult; however, it takes discipline to stick with it. Asset classes go in and out of favor, and there will be winners and low performers each year.

By its very design, a diversified portfolio will never outperform the top-performing asset class, but it also won’t finish at the bottom. Rather, it is designed to produce returns that will fall between the top- and bottom-performing asset classes. But it’s not easy to stick with a “loser” or see negative returns in your portfolio when the financial press and pundits are talking about the latest, greatest growth trend. Talking with a professional who knows your situation and can assist in building and maintaining your diversified portfolio is critical to sticking with the plan.

How do I start a diversified portfolio?

Strategically building a well-diversified, long-term plan is all about balancing trade-offs in a way that best suits you. That’s where a trusted, knowledgeable financial advisor can help. The investments you choose to make are important, but having a well-crafted plan and sticking to it plays an equally important role in building and protecting wealth over the long term.

A Northwestern Mutual financial advisor can help you see through the noise and stay focused on the big picture. Not only can the advisor build a diversified portfolio that’s tailored to you or your goals, but also his or her objective perspective and experience can help instill confidence to stick with your plan through thick and thin. The advisor’s recommendations will help you protect and prosper throughout different economic situations. You’ll be equipped with a range of financial options that give you flexibility today and in the future.

All investments carry some level of risk, including the potential loss of all money invested. No investment strategy can guarantee a profit or protect against a loss.