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Diversification is a word you hear often in the investment world. And maybe you know just enough to explain to the person next to you that it means: Don’t put all your eggs in one basket. That’s a good start, but let’s dig a little deeper.
Diversification is a strategy to help you manage your investment risks by spreading your money across a variety of investment vehicles and assets. The logic behind diversification is that by investing in a mix of assets (e.g., bonds, stocks and ETFs), your portfolio won’t be completely wiped out in the event that one investment (e.g., a particular asset or company) fails. That’s because, generally, different types of assets react differently to turbulences in the market.
Some assets are likely to perform better than others under certain market conditions. By diversifying, if one part of your portfolio isn’t doing so well, the other parts of your portfolio may be able to help cushion the ups and downs of the market.
Another important thing to understand, too, is that the primary purpose of diversification isn’t to help you maximize your returns. It’s simply a strategy to help limit your exposure to certain investment risks. To be sure, diversification has the potential to help improve your returns over time, but it does not guarantee any return on investment.
Just as diversification doesn’t guarantee gains, it also doesn’t guarantee you against losses. Investing inherently comes with risks, and these risks can never be completely eliminated. After all, no risk, no reward, right?
When it comes to investing, risk falls into two broad categories: systematic and unsystematic. Diversification can really only mitigate the latter.
Heads up: We’re about to go full nerd here, so bear with us.
Systematic risk affects the economy as a whole with impact on every company and sector. Causes of systematic risk are external, meaning they are generally out of a company’s control. Fluctuations to interest rates and exchange rates, political instability and economic recessions are some examples of systematic risks. This type of risk is generally non-diversifiable — in other words, diversification can do little to help you mitigate these broader economic risks.
Unsystematic risk, on the other hand, is company-specific or asset-specific. It is a diversifiable type of risk — the kind that we can try to do something about via a diversification strategy. Company-specific risks may arise through poor business management decisions, financial problems or legal challenges.
In short, diversification cannot eliminate all investment risks. While spreading your investments around can help offset certain portfolio losses caused by company-specific risks, diversification is usually unhelpful when it comes to facing down market-wide risks.
There are many ways to spread out your investments thanks to the plethora of assets and investment vehicles out there. To build a diversified portfolio, you have the option to invest across asset classes, within an asset class and across industries.
When investors look to diversify across asset classes, a few types of assets generally come into play. These include stocks, bonds and short-term investments like money market mutual funds. A diversified portfolio typically contains a mixture of these investments.
You may also want to seek diversification within a particular asset class. For example, when you buy stocks, you probably don’t want to put all your money in the stocks of a single company. This is where mutual funds and exchange-traded funds (ETFs) can be helpful. These funds contain a variety of bonds and stocks, so that diversification is automatically built in. Take for example an S&P 500 index fund, which holds shares in some of the largest public companies in the US.
Investors who are interested in diversification may also look into adding sector funds, which focus their investments in…you guessed it…a particular industry sector. For instance, there are mutual funds that invest exclusively in energy companies. But be careful not to concentrate too heavily in any one particular sector. Again, the goal of diversification is to minimize your exposure to certain company-specific (or in this case, industry-specific) risks.
It doesn’t have to be. Outside of the investment context, you may also apply the concept of diversification to your savings strategy. Although saving and investing are two different things, you can still talk about diversifying when it comes to managing your savings.
Instead of simply stashing all your money in a single traditional savings account, you might want to consider spreading your savings among different types of savings accounts to take advantage of their respective benefits.
For example, a certificate of deposit or a high-yield savings account can typically help you earn a higher interest rate than a basic savings account. And if a portion of your savings is earmarked for retirement, consider putting that money into an IRA or 401(k), which can offer potential tax benefits.
Remember, saving and investing are both important aspects of your overall financial strategy. So you don’t have to think of diversification as something you can only do with your investments. Go ahead, give your savings some TLC, too.
Now that you know the basics to diversification, you might be wondering how much of your money should be allocated to which assets or how much diversification is enough. Here’s the thing. There’s no simple answer to diversification, so there’s no one-size-fits-all asset allocation strategy. Talking about asset allocations is not helpful without knowing your investment goals, your tolerance for risk and your time horizon (translation: when you expect to cash in your investments).
Before going on a diversification spree, sit down with your financial advisor to discuss your goals and determine how to appropriately diversify your investments to achieve those goals within a given timeframe. Just as your investment goals might change over time, so can your diversification strategy.
And rather than thinking in terms of how much diversification is enough, ask yourself just how much risk you’re willing to take on in your portfolio to achieve your investment goals.
Want to learn more? Check out other articles from Marcus on personal finance, savings strategies and more.
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