What Is Diversification? - A Complete Guide

Diversification is an investment strategy that aims to reduce risk while maximizing return. It does this by spreading exposure to several different asset classes and within each asset class. This way, if one sector or one holding goes down, the whole portfolio won’t sink, and may even experience gains elsewhere. Experts often recommend diversification for long-term investments such as retirement accounts. For help deciding if your portfolio needs more diversification, consider working with a financial advisor.

Diversification Across Asset Classes

To professional money mangers, diversification involves investing in several different asset classes. This means that a portfolio of different individual stocks isn’t diversified. Neither is a portfolio holding only large-, mid- and small-cap mutual funds. To be diversified, a portfolio needs to hold more than one kind of asset class, and many experts would say that to be truly diversified, it should hold at least the four main kinds: domestic stocks, bonds, small-term investments and international stocks. Learn more about these asset classes and an inflation-protected sector below:

Domestic Stocks

Of the four key components of a diversified portfolio, U.S. stocks have historically generated the highest rate of return. That’s why they’re often the growth-oriented part of a diversified portfolio. Yet equities also come with a greater degree of risk in the short term. So the sooner you may need to touch your money, the less invested in stocks you’ll probably want to be. Conversely, the more time a portfolio has to recover from market swings, the more stocks you may be comfortable owning.

Bonds

While stocks seek to contribute gains to a portfolio, bonds or fixed-income securities aim to provide stability. Compared to stocks, they are safer and lower risk. They also tend to do well when the market heads south.

Bonds are basically loans to a company, government or other entity, and their return is the interest borrowers promise to pay for the loan. Treasuries and other U.S. government bonds are considered the safest (after all, they’re backed by Uncle Sam). The trade-off is that they pay a lower rate. On the other end of the spectrum are high-yield (low-quality) corporate bonds, aka junk bonds. In between are different grades of corporate bonds, municipal bonds and foreign bonds.

Short-Term Investments

In a nutshell, this asset class is practically like holding cash, but with a slightly better return. This is often described as preserving capital. Short-term investments consist of money market funds and short-term certificate of deposit (CD) accounts. CDs are covered by the Federal Deposit Insurance Corporation (FDIC) and are as safe as cash in the bank (at least an FDIC-insured one). They earn slightly more than savings accounts because a holder of a CD agrees not to move the money for a set period of time.

Like CDs, money market funds tend to earn a better rate than savings accounts. But they’re not insured by the FDIC and they could lose value. This actually happened for the first time during the Great Recession, but the risk is generally considered negligible.

Foreign Stocks

International equities generally offer higher rewards, but are higher risk. Their markets may not face the same headwinds as U.S. markets, so they can remain stable when markets here are volatile. The reverse is also true. Diversified portfolios often include a smaller percentage of foreign stocks than domestic stocks.

Real Estate Investment Funds

Investments in real estate tend to perform well during periods of high inflation. They also don’t necessarily follow stock or bond market movements, which makes them a good asset to include in a diversified portfolio. Real estate funds, which are mutual funds that specialize in public real estate companies, and real estate investment trusts (REITs), which trade like a stock, are the easiest way to get exposure to the sector.

You can also diversify your portfolio with other inflation-protected securities like commodities or funds that invest in commodity-related industries like oil, gas and mining.

Diversification Within Asset Classes

As mentioned earlier, diversification also entails different holdings within each asset class. The aim, again, is to spread exposure and risk. You can most easily diversify holdings within an asset class with mutual funds and exchange-traded funds. You can also achieve total diversification with target-date funds.

Mutual Funds

Since mutual funds pool people’s money to invest in many different companies, buying into them automatically gives you diversification. They can focus on a particular company size: large cap, mid cap and small cap. Or they can choose investments based on risk profile: aggressive, moderate and conservative. Some are index funds, which means they’re pegged to a particular index like the S&P 500. And some are blended or balanced, holding different asset classes like stocks and bonds. You can also find mutual funds that invest in special sectors, like commodities or REITs.

Exchange-Traded Funds (ETFs)

ETFs function similarly to index funds. They track indexes, which is to say, they generally hold some combination of the stocks in that index. The main difference is that you can trade them like a stock. Unlike mutual funds, you can buy and sell them throughout the day as their prices change. With mutual funds, share prices are calculated at the close of market each day.

Target-Date Funds (TDFs)

Also called lifecycle funds, TDFs are mutual funds that automatically change their asset allocation based on the investor’s age. In general, they aim to invest more heavily in growth-oriented securities like stocks when the investor is young. They gradually shift more toward fixed-income and other “safer” securities, following the mutual fund’s proprietary glide path, as the investor ages.

Because true diversification is built into TDFs, they’re one of the easiest ways to own an appropriate mix of asset classes as your time horizon changes. In fact, they’re often called one-stop shopping for retirement funds, which is one reason most 401(k) plans offer them as options.

Bottom Line

Diversification is key to reducing risk in an investment portfolio. It entails investing in different asset classes to spread the risk across different sectors of the economy. As time horizons shorten, the mix changes. With long-term investments, equities are the biggest component. When goals have shorter terms, holdings are in safer securities like fixed-income funds. Mutual funds and ETFs are the easiest way to diversify a portfolio. You may want to enlist the help of a financial advisor as you seek to diversify your portfolio properly. These are the questions you should ask a financial advisor before you decide to start working with him or her.

Tips on Diversification

A financial advisor can help you diversify your portfolio. 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.
The right mix for you depends on your time horizon and risk tolerance. To see what it is for you, use SmartAsset’s asset allocation calculator. It gives you a glimpse of what different investment portfolios may look like based on your risk tolerance.