Why Is Diversification of Investments Important?

SmartAsset: Why Is Diversification of Investments Important?

Investing money in the stock market is a proven way to grow wealth, but it’s not without risk. Diversification is a strategy that aims to manage risk while still allowing you to realize your desired rate of return. So why is diversification of investments important? Without it, you may be taking on too much – or not enough – risk to achieve your goals. A financial advisor could help you create a financial plan for your investment needs and goals.

What Is Diversification in Investing?

Diversification is the process of creating a portfolio that includes a mix of different types or classes of investments in order to balance risk and reward. Doing so can help you to manage stock market volatility over time as the market moves through different cycles.

When you diversify, you avoid what’s arguably one of the worst investing mistakes: Putting all of your eggs in one basket. Diversification is a risk management strategy that’s designed to help investors achieve the maximum level of return possible, based on their individual risk tolerance.

Diversifying investments is important because not all investments carry the same degree of risk. As market volatility increases or decreases or the economy moves through various stages, investments can react differently. That can translate to gains or losses for investors, depending on the types of investments you own.

Stocks, for example, can produce the highest returns over time but they can be subject to wide price swings, based on market conditions. Bonds, on the other hand, are more conservative investments that offer a lower rate of return to investors. But both can be central to a diversified investment strategy.

Holding a portfolio that’s 100% stocks could expose you to too much risk. If a major downturn occurs, your portfolio’s value could drop sharply and it may take months or even years for it to recover. Meanwhile, holding a portfolio that’s 100% bonds means you may not be taking enough risk to produce the level of returns you’re after.

Diversification is also important for managing inflation risk. When consumer prices rise, purchasing power shrinks. Some investments are naturally more insulated against inflation than others and can be used as a hedge to counter rising prices. Real estate, for instance, generally moves with inflation. So as consumer prices rise, property values and rental prices may rise in tandem. That can be a boon to investors who own rental property.

Benefits of Diversification

Diversifying a portfolio can potentially help you to improve your returns over time and smooth your path when navigating periods of increased volatility. Owning different investments with different risk profiles can make it easier to ride out changing market conditions, even if one part of your portfolio takes a hit.

When stocks drop, your bond holdings could make up for that if they’re still generating a steady rate of return. Or if you’re worried about how inflation is affecting your stock returns, real estate investments can help to bolster your portfolio until prices begin to normalize again. This type of approach means that your fortunes don’t rise and fall on any single investment.

If you continue to invest during market ups and downs, you can also reap the benefits of dollar-cost averaging. Rather than only buying low and selling high, you’re continually buying into the market regardless of where prices are on any given day. This is another form of diversification since you’re buying investments at different price points over a period of years. Dollar-cost averaging can help you avoid the risk associated with trying to time the market.

Diversification isn’t designed to eliminate risk entirely because it does require you to hold investments with varying degrees of risk. Again, this is central to maintaining a balance between the amount of risk you’re comfortable taking and the amount of risk you need to take in order to reach your goals. But diversifying can limit your losses to a degree if one part of your portfolio underperforms.

How to Create a Diversified Investing Strategy

Building a diversified portfolio starts with understanding your personal risk tolerance and how much risk you really need to take in order to reach your goals. This is your risk capacity. When there’s a wide gap between how much risk you’re willing to take and how much risk you need to take, it can be harder to generate your preferred level of return.

The next step in diversifying a portfolio is understanding the risk profile of different investments. Again, stocks tend to be risker than bonds or other fixed-income investments. If you’d rather not pick and choose individual stocks or bonds, you could split the difference with a low-cost mutual fund or exchange-traded fund (ETF).

These funds can offer exposure to a basket of stocks and bonds in a single investment vehicle. But mutual funds and ETFs aren’t all alike in terms of their risk profile. Index funds, for example, follow a passive investment strategy that tries to match the performance of an underlying market benchmark or index. Actively managed funds, on the other hand, tend to take a more aggressive approach that’s designed to beat the market.

Your age can play a part in choosing how to diversify. If you’re using an age-based asset allocation rule like the Rule of 110, for example, then you’d subtract your age from 110 to determine how much of your portfolio should be dedicated to stocks versus bonds. If you’re 30 years old, for instance, then a portfolio that’s 80% stocks and 20% bonds could be a good fit.

If you’re buying individual stocks or stock funds, it helps to understand the different market sectors and how those can react in changing market cycles. Some stocks are defensive, meaning they naturally tend to do better when the economy is shrinking while other stock sectors take the lead when the economy is growing. Holding a mix of both or employing a sector rotation strategy can help you to better manage risk when the economy is shifting gears.

Likewise, bonds aren’t all the same in terms of what they may return to investors and how much risk they carry. Government bonds, for instance, are virtually risk-free while junk bonds tend to be the riskiest option. But junk bonds can also offer some of the highest yields. When choosing bonds, look beyond the interest rate and yield and consider the maturity term, which can also affect risk.

Other than stocks and bonds, you may consider diversifying with real estate, precious metals or even cryptocurrency. Keep in mind that the further you stray from the standard stock and bond portfolio, the more risk you’re likely to encounter. Cryptocurrency, for example, has the potential to generate sizable returns but it’s one of the most volatile investments around.

Keeping some of your investments in cash or cash equivalents could help you to hedge your bets. For example, you can complement stocks, mutual funds or real estate with safer options like certificates of deposit, money market funds or a high yield savings account. These accounts can deliver returns in the form of interest or dividend income while offering convenient access and lower levels of risk.

Bottom Line

Why is diversification of investments important? The simple answer is that you need diversification because the market is diversified: sometimes it’s up; sometimes it’s down; sometimes it’s moving sideways. So in such variable – and unpredictable – environments you need to manage risk while working toward your investment goals. You don’t necessarily need to overload your portfolio with an A-to-Z catalog of investments. But having a solid mix of securities can help you weather the ever-changing moods of the market.

Tips for Investing

Consider talking to your financial advisor about the best ways to approach diversification in your portfolio. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Aside from risk, it’s also important to consider fees when diversifying investments. Trading stocks, for example, could trigger fees unless you’re using a brokerage that charges $0 commission fees. With mutual funds and ETFs, meanwhile, it’s important to consider the expense ratio you’ll pay. The higher the expense ratio, the more of your returns you’ll hand back each year.