What Is Portfolio Diversification? (2024)

Risk is an inevitable part of investing, but you can manage the risks you take by diversifying.

Diversification is one of the most basic and popular investing strategies available to all manner of investors, from the most sophisticated hedge funds and pension funds to college grads opening their first 401(k)s.

The idea behind diversification is simple: Don’t put all of your eggs in one basket.

Instead of, say, betting your entire savings on the stock of a single, favorite company, you aim to own stocks of several companies in different industries and some other types of investments such as bonds.

Having a balanced mix protects you in case any particular investment you own has a bad year. “You never know which asset class is going to be in favor or out of favor for the year,” says Amy Arnott, a portfolio strategist at Morningstar in Chicago.

Building a well-diversified portfolio can be as straightforward or as complex as you make it. Here’s what you need to know.

What is diversification?

Diversification is a way to reduce risk in your portfolio by dividing your money across different assets. If you haven’t thought about diversification before, you should: It’s one of the cheapest and easiest ways to lower your investing risk.

Think about it this way: If you plan to invest in the stock market, and you put all your money in a single stock, there is a small chance the stock you pick will turn out to be the next Apple or Google, and you will get rich. There is also a chance the single stock you pick will go bankrupt and you will lose your entire investment.

Much more likely than either of these outcomes, however, is that you will pick a stock that delivers more or less average long-term performance with many ups and downs—often gut-wrenching downs—along the way.

With diversification, you accept that reality—and turn it to your advantage.

When you diversify your portfolio, you hedge your bets by buying a number of different stocks (as well as bonds, and perhaps other assets). In the long run, you can assume your portfolio’s overall performance will match the long-term average of each of the different stocks in your portfolio.

But—and here is the magic of diversification—you do it without the anxiety-inducing highs and lows you’d endure if you owned any one of those stocks (or bonds) on its own.

That’s because in a year when some stocks are up, others will be down. As long as the stocks in your portfolio don’t move in lockstep, then the peaks and valleys of performance will cancel each other out.

Diversification’s ability to smooth your portfolio’s overall volatility—without sacrificing (long-term average) performance—is the reason it’s such a popular strategy.

“Diversification is what a lot of economists call a free lunch,” notes Michael Finke, a financial advisor and professor of wealth management at The American College of Financial Services in King of Prussia, Pa. “It’s the only way to consistently get a higher return for the same amount of risk.”

Pros and cons of diversification

Pros

A well-diversified portfolio can offer the following benefits:

• Lower risk and volatility. By spreading your money across various assets, your portfolio is less likely to lose a lot of value just because any single investment does. Over time, diversification can provide more stability to your portfolio.
• More consistent returns. If your portfolio’s fate doesn’t hinge on the performance of any single investment, then you often improve your returns over time. That’s because one year’s winner could just as easily become next year’s loser, and investing in various assets increases the probability you always have at least some winners to offset losers. What’s more, investing in a broad mix of assets will help you capture gains in the best-performing market at any particular time.
• New investment opportunities. Diversification lets you dabble in flashy investments, think cryptocurrency, where price moves are dictated by different factors than in the stock or bond markets. If you want to add one of these “alternative” assets to your portfolio, you can do so in small doses that add to, rather than upend, your overall mix of assets.

Cons

That said, there are some potential downsides to diversification that include:

• Potentially lower returns. A well-diversified portfolio provides more consistent returns over the long-term, but at the cost of potentially lower returns year-to-year. You won’t fully benefit from the highflying individual stocks—and a particularly bad year for one type of asset, such as bonds, could actually drag down the overall performance of your portfolio.
• Extra maintenance. If you invest in individual stocks, there’s a cost in terms of the time it will take to manage your portfolio, monitor and track each company you’re invested in, and ensure it stays well-diversified over time.
• Potential pitfalls. Investors who don’t fully understand diversification can fall into some pitfalls, such as loading up their portfolio with too-similar assets that don’t provide any diversification benefits or unintentionally making a big bet on a risky slice of a certain market, like shares of companies with the smallest market values.
• Higher costs. If you venture into investing in new assets like cryptocurrency or buy specialized funds in lieu of low-cost index funds, for example, you could face higher investing-related costs. What’s more, if you own some individual stocks that are dictating your portfolio’s performance and you opt to sell some of your holdings to better diversify your portfolio, you could be on the hook to pay capital-gains taxes.

How to build a diversified portfolio

Building a diversified portfolio goes hand in hand with decisions about your “asset allocation,” or the percentage of stocks and bonds and other types of assets in your portfolio. You’ve probably heard about a 60/40 portfolio—60% stocks and 40% bonds—which is a popular guidepost for many investors.

You may want to deviate from a 60/40 portfolio based on your age, investing goals, and how much risk you can stomach. For example, T. Rowe Price recommends the following guidelines for asset allocations:

How to Invest Your Portfolio Based on Your Age

General guidelines for how to invest your retirement money:

Source: T. Rowe Price

While diversification typically means your portfolio will include many different stocks and bonds, achieving this doesn’t need to be complicated. You could build a well-diversified portfolio by buying just two index mutual funds or exchange-traded funds—one that tracks the performance of the total U.S. stock market and another that tracks the U.S. bond market. This strategy, while simple, doesn’t skimp on diversification benefits because each fund is made up of dozens, if not hundreds, of different securities.

“For 80% to 90% of people, ETFs are the way to go because they offer instant diversification, they’re tax-efficient, and they’re low-cost,” says Derek Horstmeyer, a professor of finance at George Mason University in Fairfax, Va.

6 components of a diversified portfolio

U.S. stocks and bonds are the cornerstone of a well-diversified portfolio. Whether you focus on additional diversification strategies is up to you—you can choose your own adventure.

However you go about diversifying your portfolio, keep this guidepost in mind: Any particular asset—like an individual stock—should represent no more than 5% to 10% of your portfolio’s value. Beyond this threshold, this investment will pose a greater risk to your overall portfolio, notes Roger Young, a financial planner with T. Rowe Price based in the Baltimore area.

Common components of a diversified portfolio include U.S. and international stocks, government and corporate bonds, gold, cash, and cryptocurrency. Here’s what to know about each.

Domestic stocks

Stocks are among the riskiest investments, and often experience wild price swings in the short-term. Patient investors are often rewarded with higher returns, but you must be prepared to ride out some turbulence when investing in stocks.

A portfolio invested 100% in the U.S. stock market delivered a quite-healthy average annual return of 12% between 1926 and 2021, according to data compiled by Vanguard. But there were some bumps along the way: That same portfolio lost value during more than one-quarter of those years (see below.)

If you opt to buy individual stocks, achieving “peak diversification” isn’t as difficult as you may think. A 2021 study co-authored by Horstmeyer found that adding more stocks to an investment portfolio made it less volatile until it included about 20 stocks—after that, the benefit was negligible.

Just make sure to invest in companies of various sizes or that operate in different sectors of the economy. For example, if you own tech stocks like Apple or Microsoft, you should balance out your portfolio by buying shares of companies in the healthcare, financial services or consumer-focused sectors, along with funds that track an index made up of companies with small-market values.

Find the Right Mix of Stocks and Bonds for You

How various stock and bond mixes performed, 1926-2021

Source: Vanguard

International stocks

When the economy enters a recession, U.S. stocks can fall across the board in what’s known as a bear market. Fortunately, while the U.S. is ailing, economies (and stock markets) elsewhere may be thriving. You can turn this to your advantage by investing in international stocks.

And this type of strategy would have paid off in 2022, for example, when the S&P 500 fell more than 18% stocks in Argentina, Brazil and Chile rose by double digits and Turkey’s stock market surged more than 105%.

Most financial advisors recommend that roughly one-third of your stock market holdings should be international stocks (albeit with far smaller amounts in developing economies, like the ones mentioned above.)

If you are worried about the prospect of researching foreign companies, don’t be. There are plenty of index funds and other mutual funds that target international stocks, whether you are looking for a single fund that will give you a smattering of stocks from around the world, one that focuses on just developed markets, or even individual countries.

Bonds

Bonds are the classic tool for balancing out risks in the stock market. While bonds offer lower returns than stocks, they’re less volatile—which provides stability to your portfolio when the stock market is in turmoil. Bonds are also attractive for another reason: They pay regular income.

Adding bonds will likely lower your long-term returns—but history shows that comes with a benefit. As the Vanguard data above show, none of the portfolios that included bonds matched the all-stock portfolio’s 12% long-term return. But investing in bonds helped these portfolios to dodge many down years, and that was especially true for portfolios that were majority bonds. The worst year ever faced by 60% bond, 40% stock portfolio was a decline of around 18%, compared with a decline of more than 40% for a portfolio that included just stocks.

There are a variety of ways to diversify your portfolio when investing in bonds. As with stocks, you may find it easier to buy bond funds instead of individual bonds. U.S. Treasury bonds are a popular choice for many investors, and you can include a mix of short-term bonds that mature within two years or long-term bonds that mature in 10 or more years. If you invest in corporate bonds, you can include a mix of investment-grade and high-yield bonds.

Cash

You might not think of cash as an investment, but it’s another valuable way to diversify your portfolio. Money in short-term investments, like a money-market account or a high-yield savings account, is easy to withdraw if you need some cash quickly.

Having some cash on-hand can be especially helpful for riding out the most turbulent times in markets. When stock prices are falling, you may be less tempted to sell at a bad time—and that cash could even allow you to jump in and invest when prices are down.

Gold

Gold is a popular way to hedge against risk in other assets, and there are several ways to invest in gold—including buying exchange-traded funds (ETFs), gold mining stocks or owning the metal itself.

Gold often retains—or even increases—in value when other asset prices fall, making it “a pretty reliable safe haven,” Arnott says. That’s why you may want to invest a small percentage of your portfolio—say, 5%—in gold, she adds.

Other assets

Investing in other types of assets can improve your portfolio’s performance and reduce risk still further. Just be careful, many of these assets—like agricultural commodities, currencies and cryptocurrencies—are exotic and volatile.

Horstmeyer advises these investments shouldn’t exceed 5% to 10% of your portfolio.

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