While every investment comes with some degree of risk, there are ways of limiting your exposure while still letting your money grow. Diversification, or spreading your money over different investments, is one way to do that.
What is diversification?
Diversification is the strategy of spreading money across different types of assets, allowing money to grow while limiting exposure to risk. A diversified portfolio might include a variety of asset classes, such as stocks and bonds, along with real estate and cash equivalents.
An asset class is a group of securities that share similar characteristics, tend to follow the same trends in the marketplace, and are subject to the same laws and regulations. Including stable investments in the mix can help absorb the shocks of financial disruptions.
Asset allocation is the way investors divide their money among those different asset classes. For example, someone might put 65% of their investments in stocks, 20% in bonds, 10% in real estate, and 5% in cash. There are more ways to further diversify, such as within each asset class, and the exact recipe depends on the investor’s investment time horizon, financial needs, and comfort with volatility.
Diversification isn’t a one-and-done task, though. Once an investor establishes their risk tolerance, investment horizon, and asset mix, they’ll try to keep it on track with periodic checkups and rebalancing. Investors typically lower their risk as they get closer to retirement, so they’ll shift their asset allocation accordingly.
Downsides to diversification
Of course, there are certain downsides to diversifying. Individuals might not have the time or experience to manage their investments, and anything that works to reduce their risk may also reduce their potential return.
However, there are ways to simplify the process; for instance, individuals can invest in a mutual fund, which pools money from many investors to buy a mix of stocks, bonds, and other assets. These are professionally managed, so they may benefit from the fund manager’s time, resources, and expertise.
Index funds are passively managed and designed to track the composition and performance of a financial market index, such as the S&P 500. Some funds might invest across several asset classes in both domestic and international markets, which takes care of the diversification.
Ways to diversify your portfolio
Some of the most common ways to diversify a portfolio include diversifying in different asset classes, within each asset class, and in different markets around the world.
Across asset classes
Investors might choose to put their money in several asset classes to increase diversification and reduce volatility. So if an economic disruption causes stock prices to rise and bond prices to fall, a portfolio that contains both stocks and bonds would be partially protected. In this example, bonds lost money, but stocks made up for those losses.
The major asset classes all do different things and come with different growth potential.
- Stocks. Also known as equities, stocks allow investors to own a piece of a company. These often provide the highest returns.
- Bonds. Bonds, which bring in income by paying interest, generally have an inverse relationship with stocks and generate less volatility and more modest returns.
- Real estate values. These typically move in the opposite direction as stocks. This type of investment is thought to provide stability and a hedge against inflation.
- Commodities. These are basic goods—such as agriculture products, raw materials, and precious metals—that can be traded globally on a specialized exchange. Commodity prices tend to move in opposition to stocks, and some prices are more volatile than others.
- Cash. This includes liquid investments such as currencies, money market accounts, Treasurys, and CDs.
Within a single asset class
Investors can further diversify within a single asset class using different strategies.
Stocks
Individuals may decide to invest in companies across different sectors or industries, such as energy, financial, health care, and technology. They can also spread money across companies of different sizes (also known as market capitalization). Large-cap, mid-cap, and small-cap companies all offer different benefits. For instance, larger companies are more stable and can weather economic downturns more easily—but smaller companies often have more growth potential.
Bonds
These fixed-income investments are available through various issuers, including the US government, state and local governments, and corporations. Bonds have different levels of creditworthiness and maturity terms, so investors can diversify with varying credit qualities, maturities, and durations, which measure sensitivity to interest-rate changes. Bonds with longer maturities and higher risk factors generally yield higher returns than short-term bonds with strong credit ratings.
Cash
Many investors keep a minimum amount of cash on hand to handle emergencies—usually equivalent to three to six months’ worth of typical expenses. This money can be kept in a money market account, certificate of deposit, or high-yield savings account. Investors can also move some of their stocks and bonds into a cash position within a 401(k) plan, individual retirement account (IRA), or brokerage account.
Real estate
Buying a home to live in can be a good way to start investing in real estate, since homeowners build equity over time as they pay down the mortgage principal and home values rise. Taking it a step further, investors can buy and rent out an investment property to create passive income, and real estate investment trusts (REITs) provide options for those who want to invest in real estate without owning the physical property.
Commodities
To invest in commodities, individuals might buy stocks and corporate bonds from commodity producers or buy shares in a commodity exchange-traded fund (ETF). Investors can even buy precious metals such as gold, which is available in coin and bar form from precious metals dealers.
Geographically
Investors can also incorporate stocks and bonds in markets around the world, which have the potential for high returns in a short time frame. Countries tend to go through different economic cycles, which can help maintain buying power.
Foreign markets are classified into two main categories:
- Developed markets. European nations, Australia, Japan, and Singapore tend to have more stability, but provide lower returns.
- Emerging markets. Brazil, Russia, India, and China tend to be more volatile, but have higher growth potential.
Investing in a foreign market may require a learning curve. Beginning investors tend to budget time to learn about trends in the economy and what drives them, and understand that they may need to deal with different monetary regulations.
The bottom line
Diversification is an important part of investing because it reduces risk while allowing money to grow. To determine an asset mix, investors need to consider their time horizon, goals, and risk tolerance. Generally, investors are more willing to handle risk when they’re further from retirement. But they’ll need to determine their own asset mix, which may involve investing across asset classes, within asset classes, and both domestically and abroad.
