Diversification is a fundamental investment strategy that involves spreading investments across various financial instruments, industries and other categories to reduce exposure to any single asset or risk. By not putting all their eggs in one basket, investors can mitigate the impact of poor performance from any one investment. Diversification can help achieve more stable and predictable returns over time, making it an important part of financial planning.
Need help putting together a financial plan and diversifying your assets? Consider reaching out to a financial advisor.
How to Use Diversification to Reduce Risk in a Portfolio
Different assets often react differently to the same economic events. For example, there is a tendency for stocks to decline during a market downturn, while bonds remain stable. However, you should also note that the correlation between these two assets can also change during periods of high inflation. Rising prices could make stocks underperform and rising interest rates used to curb inflation could make bond prices fall as well.
Nevertheless, by spreading investments across different asset classes, geographic regions and sectors, investors can reduce the impact of individual asset volatility on their overall portfolio. A common diversification strategy when there is no inflation is to invest in a balanced mix of stocks, bonds and cash equivalents. And to diversify during inflation, you can consider investing in a mix of assets including commodities, real estate, inflation-protected securities and stocks from sectors that tend to perform well during those periods.
Here are five common strategies to diversify an investment portfolio:
- Spreading investments across asset classes. Diversifying your portfolio involves spreading investments across different asset classes, such as stocks, bonds, real estate and commodities. Each asset class has its own risk and return characteristics and often reacts differently to the same economic events. And by allocating investments across various asset classes, you can reduce the impact of a poor-performing asset on your overall portfolio, thereby lowering your overall risk.
- Geographic diversification. Economic conditions and market performance vary across regions. For example, while one country’s economy might be struggling, another’s could be thriving. By diversifying geographically, you can protect your portfolio against localized economic downturns and benefit from growth in different parts of the world. This approach helps to balance out regional risks and enhance potential returns.
- Sector diversification. Another way to diversify is by spreading investments across different sectors of the economy, such as technology, healthcare, finance and consumer goods. Each sector can be affected differently by economic changes, technological advancements and regulatory shifts. For example, technological innovations might boost tech stocks while regulatory changes could impact the healthcare sector. By investing in a variety of sectors, you can minimize the risk of one sector’s downturn adversely affecting your entire portfolio.
- Diversification within asset classes. Even within a single asset class, diversification can play an important role. For example, within a stock portfolio, you can invest in companies of various sizes (small-cap, mid-cap and large-cap) and industries. Similarly, in a bond portfolio, you can include government bonds, municipal bonds and corporate bonds with varying credit ratings and maturities. This internal diversification ensures that the poor performance of one investment does not overly affect the overall portfolio performance.
- Diversification among investment funds. Mutual funds, index funds and exchange-traded funds (ETFs) are effective tools for diversification. These funds pool money from many investors to purchase a diversified mix of assets. They provide instant diversification across a wide range of securities, which might be difficult for an individual investor to achieve on their own. For example, a single ETF might include hundreds of different stocks, spreading risk across numerous companies and sectors.
Implementing a Diversification Strategy
To effectively diversify your portfolio, it can help to start by assessing your risk tolerance, investment goals and time horizon, and then allocating your investments across various asset classes and sectors according to these factors. It’s also a good idea to regularly review and rebalance your portfolio’s asset allocation to maintain the desired level of diversification, especially in response to significant market movements or changes in your financial situation. You could also consider consulting with a financial advisor. A financial advisor can provide personalized guidance and help you create a well-diversified portfolio tailored to your specific needs.
Bottom Line
Diversification helps to reduce risk in an investment portfolio by spreading investments across various asset classes, geographic regions, and sectors. This can minimize the impact of any single asset’s poor performance, balances regional economic fluctuations and mitigates sector-specific risks. Diversifying within asset classes and using investment funds like mutual funds and ETFs adds another element of risk management.
Risk Management Tips
- Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- A great way to plan for retirement is to calculate how much you’ll need after you retire. Think about the things you’d like to do after your retirement. Do you want to travel? Also, think about where you want to live and what kind of lifestyle you want. For example, you’ll need to save more if you want to retire in a place with a high cost of living. SmartAsset’s retirement calculator can tell you how much you should save each month in order to reach your goals.
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