Diversifying Your Portfolio Reduces Your Risk in Investing. Here’s Why That’s So Important
Investing is one of the best ways to buildwealth and reach your long-term financial goals. But what should you invest in?While there’s no one right answer for everyone, there is one principle that canhelp guide your investing decisions: diversification.
“No matter what your goal is, diversificationis a key to investing,” says Corbin Blackwel
As with many things in the world of finance,diversification seems complicated at first. But we’ve spoken with two investingexperts to help break down what exactly diversification means, how diversifiedyour portfolio should be, and how to start diversifying your portfolio rightnow, even with a small amount of money.
What Does it Mean to Diversify Your Portfolio?
When you diversify your portfolio, youincorporate a variety of different asset types into your portfolio.Diversification can help reduce your portfolio’s risk so that one asset orasset class’s performance doesn’t affect your entire portfolio.
There are two ways to diversify yourportfolio: across asset classes and within asset classes. When you diversifyacross asset classes, you spread your investments across multiple types ofassets. For example, rather than investing in only stocks, you might alsoinvest in bonds, real estate, and more.
When you diversify within an asset class, youspread your investments across many investments within a certain type of asset.For example, rather than buying stock in a single company, you would buy stockfrom many companies of many different sizes and sectors.
How diversification benefits you
Diversification has several benefits for youas an investor, but one of the largest is that it can actually improve yourpotential returns and stabilize your results. By owning multiple assets thatperform differently, you reduce the overall risk of your portfolio, so that nosingle investment can hurt you. It’s this “free lunch” that makesdiversification a truly attractive option for investors.
Because assets perform differently indifferent economic times, diversification smoothens your returns. While stocksare zigging, bonds may be zagging, and CDs just keep steadily growing.
In effect, by owning various amounts of eachasset, you end up with a weighted average of the returns of those assets.Although you won’t achieve the startlingly high returns from owning just onerocket-ship stock, you won’t suffer its ups-and-downs either.
While diversification can reduce risk, itcan’t eliminate all risk. Diversification reduces asset-specific risk – thatis, the risk of owning too much of one stock (such as Amazon) or stocks ingeneral (relative to other investments). However, it doesn’t eliminate marketrisk, which is the risk of owning that type of asset at all.
For example, diversification can limit howmuch your portfolio falls if some stocks decline, but it can’t protect you ifinvestors decide they don’t like stocks and punish the whole asset class.
For assets sensitive to interest rates, suchas bonds, diversification helps protect you from a problem at a specificcompany, but it won’t protect from the threat of rising rates generally.
Even cash, or investments such as CDs or ahigh-yield savings account, are threatened by inflation, although deposits aretypically guaranteed from principal loss up to $250,000 per account type perbank.
So diversification works well forasset-specific risk, but is powerless against market-specific risk.
How to develop adiversification strategy
With the advent of low-cost mutual funds and ETFs, it’sactually simple to create a portfolio that’s well-diversified. Not only arethese funds cheap, but major brokerages now allow you to trade many of them atno cost, too, so it’s tremendously easy to get in the game.
A basic diversified portfolio could be as simple asholding a broadly diversified index fund such as one based on theStandard & Poor’s 500 index, whichowns stakes in hundreds of companies. But you’ll want some exposure to bonds aswell to help stabilize the portfolio, and guaranteedreturns in the form of CDs help, too.Finally, cash in a savings account can also give you stability as well as asource of emergency funds if you need it.
If you want to expand beyond this basic approach, you candiversify your stock and bond holdings. For example, you might add a fund thatowns companies in emerging markets or international companies more generally,because an S&P 500 fund doesn’t own those. Or you may opt for a fund comprisedof small public companies, since thattoo is outside the S&P 500.
For bonds, you might choose funds that have short-termbonds and medium-term bonds, to give you exposure to both and give you a higherreturn in the longer-dated bonds. For CDs, you can create a CDladder that gives you exposure tointerest rates across a period of time.
Some financial advisors even suggest that clientsconsider addingcommodities such as gold or silver totheir portfolios to further diversify beyond traditional assets such as stocksand bonds.
Finally, however you construct your portfolio, you’relooking for assets that respond differently in different economic climates. Itdoesn’t create diversification if you have different funds that own all thesame large stocks, because they’ll perform mostly the same over time.
And if all this sounds like too much work, a fund or evena robo-advisor can do it for you. A target-date fund will move your assets from higher-return assets (stocks)to lower-risk (bonds) over time, as you approach some target year in thefuture, typically your retirement date.
Similarly, a robo-advisorcan structure a diversified portfolio to meet a specific goal or target date. In either case, you’re likely to paymore than if you did it yourself, however.
