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Diversification: Definition & Why It’s Important

March 15, 2022
7
min

Diversification is a tool for managing a portfolio’s exposure to volatility and a broad array of various types of risk. A way investors can reduce their exposure to risk.

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All investors must accept the idea of risk. Markets can be volatile, and political instability, inflation, interest rates, and other events cause investments to rise and fall in a way that no investor can control.

Investors diversify their portfolios to limit their exposure to any one type of asset. This practice is designed to reduce risk and the fluctuations in the value of a portfolio. It is also intended to balance risk and reward. Some investment types are more volatile, but potentially more lucrative, while others are more dependable, but with a lower potential rate of return. Most investment experts agree that while diversification is an important tool in minimizing risk to maximize the long-term potential for an investment portfolio, it is no guarantee against loss.

What is diversification?

Diversification is the strategy of spreading money across different types of assets, in an effort to manage risk and reward. The basic idea is to avoid putting too many or all financial eggs in one basket. 

The first step towards diversification is through the process of asset allocation. This means selecting an asset class, such as stocks, bonds, commodities, cash and devoting funds to each. To achieve diversification, the investor then spreads money within the asset classes. For stocks, this might mean owning shares in an array of companies varying sizes and in different industries. For bonds, it could mean owning a mix of government, agency and corporate bonds with different risk profiles, yields and maturities.  

Components of a diversified portfolio

Although there are other types of investments that people use to create a diversified portfolio, the three main components are: 

  • Stocks. Investing in equities provides the highest potential for long-term growth. The most aggressive asset class in which to allocate funds, it also comes with higher potential risk.
  • Bonds. A bond is a fixed-income asset that represents a loan an investor makes to a corporation, government or agency. Bond prices correlate inversely with interest rates: when rates rise, bond prices fall and vice versa. Bonds are considered less volatile than stocks and, because they sometimes move in opposition to equities, can buffer a portfolio against the vicissitudes of the stock market. Investors who favor security may buy U.S. Treasury bonds;  those who are willing to take on just a little more risk might invest in high-yield and international bonds, which can offer higher returns than Treasury bonds.
  • Cash. Cash is the money in your checking or savings account. It is completely liquid. Some investment experts recommend diversifying a portfolio with some cash holdings because it can serve as an anchor to limit losses during market declines. Those with cash holdings might not have to sell stocks or bonds in the event of an emergency and forgo potential future profits. Cash holdings also allow investors to buy stocks they see as undervalued.

Those who are focused on diversifying their portfolios may turn to other types of investments such as:

  • Money market funds and short-term certificates of deposit. These conservative short-term investments are stable and offer easy access to funds. Money market funds usually have lower returns than bonds or bond funds.
  • International stocks. Companies not based in the U.S. can offer different opportunities than domestic stocks, as well as potentially higher risk and return.
  • Real estate funds. Investors sometimes add real estate funds, including REITs (real estate investment trusts) to diversify their portfolio and allow them to invest in the real estate market without buying the property directly. Real estate is seen as a hedge against inflation because the value of the property can increase when prices are rising, increasing the investor’s potential return.
  • Asset-allocation funds. Some funds are managed with specific goals, including diversification. Investors who don’t have the time to research asset allocation sometimes turn to these types of funds.

What might make up a diversified portfolio?

Once investors have identified how they want to weigh their holdings of stocks, bonds, and cash, they often then begin diversifying within those asset classes.

For instance, they might consider investing in more than a single industry. Holding healthcare, technology, and financial-services stocks is more diversified than concentrating funds in technology stocks alone.

Investors might also invest in different kinds of companies within each industry. They may also look at companies with different market capitalizations, such as small-cap companies versus large-cap stocks.

Here are examples of diversification within asset classes:

  • Stocks. Investors can hold multiple sectors, and industries; diversify by size or market cap; and style (growth stocks, value stocks, socially responsible).
  • Bonds. Investors can hold bonds issued by the U.S. government, states and municipalities, and corporations; bonds associated with various credit risks; and bonds with varied maturity terms.

Why is diversification so important in investing?

No investment comes without risk, and risk can be divided into two general categories:

  • Market risk (systematic risk). This risk is the kind that can affect any company or industry, such as inflation, political instability, interest rates, or exchange rates. It is a fact of investing and isn’t specific to any one company, so investors can’t always avoid it by diversifying within a portfolio of public equities. It can be managed by asset allocation, however. Real estate can be a hedge against inflation, for instance, and certain derivatives gain in value when interest rates rise.
  • Asset-specific risk (unsystematic risk). This type of risk can be mitigated by diversifying because it is specific to companies, industries, and markets.

Investors can reduce their unsystematic risk exposure by diversifying their investments among sectors, and then further diversifying according to companies of different sizes, industries, and locations.

Consider this example: If an investor had a portfolio that held only hotel and restaurants stocks before the global pandemic, their whole portfolio would have dropped because those industries experienced devastating closures and plummeting stock prices. Had that investor also invested in online retailers and delivery services, which benefited from the shift to working from home, those investments would have worked to counterbalance losses in their hotel and restaurant holdings.

What are the potential drawbacks of diversifying?

Diversification can potentially limit upside, and come with costs—in terms of both money and time. 

  • When investors reduce their risk exposure, they also decrease the potential for reward. 
  • Buying and selling assets to achieve diversification costs money, because most transactions come with brokerage fees and other expenses. These costs come out of your bottom line.
  • Diversification also takes time to research and manage if you’re doing it yourself. A widely diversified portfolio with many holdings can be difficult to monitor.

What to consider when implementing a diverse investing strategy

The decision to diversify is personal, and those who are considering diversifying over concentrating generally factor risk tolerance and time horizon into their decision.

  • Time horizon. The idea is that the longer you have to invest, the more risk you might consider taking on. Financial advisors usually think in terms of short (fewer than five years), medium (within 10 years), and long-term horizons (more than 10 years) when they advise investors on asset allocation. When investors have a long horizon, they generally have more time to recover from market losses.
  • Risk tolerance. Regardless of time horizon, some investors simply have more tolerance for risk than others. Risk-averse investors often stick with more diversified portfolios.

An investor’s time horizon and risk tolerance constantly shift. Those who began investing 25 years before retirement may slowly rebalance a portfolio from a long time horizon to a medium time horizon, then shifting to a short time horizon. This would be reflected in the way they diversify their portfolio.

The bottom line

Diversification is a tool for managing a portfolio’s exposure to volatility and a broad array of various types of risk. Investors can reduce their exposure to risk by diversifying among asset classes, and further diversifying among regions, sectors, industries, and companies. An investor’s individual risk tolerance and time horizon will influence asset allocation decisions. There is no way for an investor to guarantee against loss, since risk is inherent in investment.

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