What is diversification? Understanding portfolio diversification strategies to minimize losses (2024)

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• Diversification is an investment strategy that means owning a mix of investments within and across asset classes.
• The primary goal of diversification is to reduce a portfolio's exposure to risk and volatility.
• Since it aims to smooth out investments' swings, diversification minimizes losses but also limits gains.

If you're familiar with the proverb, "Don't put all your eggs in one basket," you understand portfolio diversification in investing.

Diversification is all about spreading out your money into multiple investments and kinds of investments through strategies like rebalancing and risk management. The idea is that your investment portfolio won't be significantly affected if one particular asset (or group of assets) loses money.

Many of the best robo-advisors offer instant diversification through customized and pre-built ETF portfolios. However, the diversification of ETFs will only get you so far. Getting well-rounded exposure to numerous market sectors is the safest way to build wealth through the stock market.

What is diversification?

Portfolio diversification is the process of dividing the funds in your investment portfolio across and within multiple asset classes (aka your asset allocation). It offers a safety net that can help investors limit risk without significantly diminishing long-term returns.

"Through intelligent portfolio building and diversifying, investors can create a portfolio of risky assets with an aggregate volatility that is lower than any of the individual securities," explains Nathan Wallace, principal wealth manager at Savvy Advisors.

For example, if you put all of your money into one stock, your entire investment could be wiped out if that company were to fail. However, you spread your risk by investing in stocks from 20 companies. Even if five stocks lose value, you can still make money if the other 15 appreciate value.

"The key here is to buy securities with attractive risk profiles that are not correlated to each other in a significant way with the goal that when one asset is performing poorly, another asset will pick up the slack through positive performance," says Wallace.

Diversification can significantly reduce your overall exposure to risk, but even the most thoughtful diversification strategies can't completely eliminate losses. Different investments are subject to different influences and different degrees of volatility (price swings). In a well-diversified portfolio, these assets balance each other and are able to keep your finances and growth on an even keel.

Related to the idea of diversification, the invisible hand theory of the market, from famed 18th-century economist Adam Smith, describes how the market will naturally adjust and reach equilibrium due to the unseen forces of individuals acting in their own best interest. For example, by making trades or buying stocks that benefit them, investors collectively help balance the market to the benefit of everyone.

How to diversify your portfolio

When financial advisors talk about diversification, they are referring to various strategies to strengthen your portfolio. Key elements of portfolio diversification include:

Diversification across asset classes

When it comes to investing, assets fall into two major categories:

• Traditional: Traditional investments refer to assets like stocks, bonds, and index funds.
• Alternative: Alternative investments refer to assets like REITs, cryptocurrencies, gold, and other commodities.

Traditional investments and alternative investments don't typically overlap. If the market were to take a dive, your stocks and bonds would deplete in value. However, commodities like those available through the best commodity brokerages won't be directly impacted.

Regardless, make sure to diversify your assets in a way that helps you reach your financial goals.

Diversification within asset classes

In addition to diversifying across asset classes, it's important to consider diversification within asset classes. This is especially true with something like stocks, which is probably the largest, most varied of the asset classes out there.

You can parse stocks in a variety of ways. One of the most common methods is to consider them by sector. Examples of market sectors include:

• Energy
• Industrials
• Financials
• Technology

For example, it wouldn't be ideal to only invest in tech companies since they are all part of the same sector and, therefore, susceptible to the same strengths and weaknesses. Investing in stocks of other sectors could help you build a more well-rounded portfolio because they possess different characteristics and might respond differently under different economic conditions.

International market diversification

You can further diversify your portfolio with exposure to global markets. By investing in foreign stocks and other international assets, you'll further mitigate potential losses in the event that the US market takes a hit.

It should be noted that investing in international stocks poses its own set of risks, including risks around currency exchanges, politics, and economics. Investors should thoroughly research a country's financial well-being, economy, and market history before throwing down cash.

Drawbacks of diversification

Diversification is, in many ways, a no-brainer. But there are always drawbacks. Here are two to keep in mind:

1. Diversification, by design, limits your returns to the "averages." You're betting on a lot of companies/types of investments with the goal that you'll have more winners than losers. But the clunkers will drag down the stars. So, while diversified portfolios should see fewer massive downturns than aggressive (less diversified) portfolios, they're also less likely to see extreme highs.
2. Diversification can be costly and time-consuming. Researching dozens or hundreds of stocks and bonds can take a lot of effort. Plus, buying a variety of different investments can be expensive, especially for the individual investor.

The second reason is why mutual funds, index funds, and exchange-traded funds (ETFs) have become the go-to for individual investors. Buying into these baskets of securities helps you achieve instant diversification — not only within asset classes but across them.

For example, below are three popular mutual fund types:

• Growth funds: Invest in companies that are expected to enjoy faster-than-average gains and tend to be the most volatile.
• Income funds: Invest primarily in dividend-paying stocks and focus on long-term income rather than short-term capital appreciation.
• Balanced funds: Offer the most diversification by investing in stocks, bonds, and cash equivalents for both capital appreciation and income.

Tips to diversify your portfolio

Here are three other tips for diversifying your portfolio:

• Keep a close eye on your investing costs: Fund costs, trading commissions, and advisory fees can cut into your overall returns. Try to avoid costly fund transaction fees and loads (commissions), and be sure to compare fund expense ratios.
• Consider target date or asset allocation funds: Asset allocation mutual funds or ETFs invest in a preset mix of stocks and bonds (80/20, 70/30, or 60/40) at all times and rebalance automatically. And target-date funds take things a step further by consistently adjusting toward a more conservative mix as you get closer to retirement.
• Rebalance regularly: As certain assets in your portfolio overperform (or underperform), your portfolio's weightings can move away from your target allocation. By rebalancing your portfolio once or twice per year, you'll ensure that your asset allocation is always consistent with your tolerance for risk.

Another important note: incorporating different types of diversification in your portfolio will better protect your assets.

"If an investor owns both a European fund and a US stock fund, they may think of themselves as diversified, but in reality, the correlation between European stocks and the US stock market has varied from about 70% to above 90% over the past decade," states Wallace. "This means that when US markets were down 10%, European markets were down between 7% and 12%. Despite the geographic diversification, investors are still exposed to risk and are not all that diversified."

Diversification — Frequently asked questions (FAQs)

The importance of portfolio diversification

Diversification is a simple concept, even if there are many ways of achieving it. Diversifying your portfolio isn't a "set it and forget it" activity. As your goals change or you age, it's likely that you'll need to tweak your asset allocation.

"There are many tools out there to track investments over time. If you have a financial advisor, your custodian will keep records of your investments and provide periodic updates to you," says Wallace.

Bear in mind that the goal of diversification isn't to maximize returns but rather to limit the impact of volatility on a portfolio. In other words, diversifying is a defensive move. But it's one that every investor should make, at least to some degree.

Diversification and portfolio rebalancing should be part of your financial plan to help you reach your financial goals. If you need help creating or maintaining a financial plan, reach out to a financial consultant or CFP for expert guidance and advice.