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A certificate of deposit (CD), or time deposit, can be a good option as a savings vehicle for a child. They allow you to deposit money for a specific term (e.g. a few months to a few years), and pay a fixed rate of interest.

CDs are relatively safe investments; they are federally insured for up to $250,000, and can offer minimal but steady growth for a period of years. They also offer parents the chance to explain the value of compound interest to their child.

Any adult can open a custodial account for a child who will assume management of the account when they reach adulthood. There are some pros and cons you should know before opening a CD account for a child, including how CDs compare to other investment vehicles for your child.

Understanding Certificate of Deposits

A certificate of deposit savings option is a bank product much like a savings account. The CD or account holder deposits the funds and agrees not to withdraw the money for a period of time, in effect, loaning the money to the bank. The bank pays the CD holder interest on the amount based on the total amount deposited and the maturity date of the CD (the term). Meanwhile, the bank invests the funds to make a return elsewhere.

You can open a CD with a bank or a credit union; this can be done in person or online. Most CDs are federally insured up to $250,000, no matter where the account is held.

If the account holder decides to withdraw the funds before the end of the term, they are typically charged an early withdrawal penalty, often forfeiting a portion of the interest. For example, if you deposit $1,000 in a 2-year CD, and you want to withdraw the funds after one year, you would only be entitled to the amount of interest earned up until that point, minus any fees or penalties.

CDs are considered a conservative investment, but the interest earned on a CD is minimal because they are low risk. When opening a CD account for a child, it’s important to consider whether the peace of mind and a lower return is what you’re after, or whether you’d like an investment that offers more growth (but possibly more risk).

Can a Child Have a Certificate of Deposit?

All things considered however, a CD for kids is a good choice because it can be a solid start to an investment plan for your child, and a way to help explain the dynamics of saving and what it means to earn interest on your principal deposit.

That said, minors cannot hold CDs. An adult must acquire a CD for the child and then transfer it when the child reaches adulthood. Depending on how much time you have, the custodial adult can also consider CD laddering, which is a technique where you hold several CDs with separate maturity dates to create steady returns.

Another point to remember about a CD for kids is that funds held in CDs and other savings accounts can affect a child’s eligibility for future financial aid. This is an important consideration, which could affect how much a family might pay for college tuition.

Who Would Own the CD?

A minor cannot apply for a CD, but they do own it. That means that the account cannot be given to anyone else.

An adult, usually a parent or legal guardian, can open a custodial account for a minor under the Uniform Gifts to Minors Act (UGMA). A custodial account allows one person to deposit funds into an account for another. The account can be transferred to the child once they reach adulthood. The age of adulthood is not federally mandated. However, in most states, it is age 18.

How to Give a Certificate of Deposit to a Minor

Here’s how to set up a CD for a minor child, and transfer the account to them when they reach adulthood.

Select the Bank Where You Want to Purchase the CD

Decide which bank or credit union you want to hold the CD for your minor child. Compare interest rates based on the amount you intend to deposit and the term for the CD. Also, look at any penalties and fees the bank might charge.

List Yourself as the Custodian and the Child as the Owner

Fill out the form online or in person stating that you will be the custodian and the minor will be the owner of the CD. You will be asked to provide identifying information such as your Social Security number and the child’s Social Security number.

Deposit the Money in the CD

Deposit the desired amount into the CD account, taking into consideration how different amounts and terms might affect the interest rate paid.

Discuss What to Do With the Funds

Opening a CD account for a child presents a “teachable moment,” in that the minor child, who is the owner of the CD, needs to think through what the money can be used for once the CD reaches maturity. When the CD matures, you can cash it out, or renew the CD. If the child is of legal age at that point, the account is transferred to the child, you may have to contact the bank to remove your name from the account.

Recommended: What are no penalty CDs?

Are CDs a Good Choice to Help My Child Save?

CDs are among the low risk investment options, and a good way to help a child save. Anyone can open a CD, and they do not have to be related to the child.

That said, CDs are also low-yield investments, and funding a 529 college savings plan might offer more growth potential over time, if that’s your goal.

For longer-term savings, opening a Roth IRA may also be a good choice for parents hoping to provide financial security for their child.

Tax Implications of CDs for Kids

Opening a CD for kids isn’t complicated from a tax perspective. Taxes are typically due on earnings when the CD matures, but a child will likely be in a lower tax bracket than an adult, so the earnings could be taxed at a lower rate.

Specifically, if all of a child’s earnings are less than $1,050, including interest, dividends, or other earnings, the earnings are not taxed. Any earnings between $1,050 and $2,100 are taxed at the child’s rate. Any amount over $2,100 in earnings is taxed at the parent’s rate.

The custodian of a CD should be aware that they can give up to $15,000 each year to a child without owing gift taxes.

Financial Aid Implications of CD Earnings

There are some implications regarding financial aid. If a child is applying to college and has savings in a UGMA, those assets will have to be disclosed on the Free Application for Federal Student Aid (FAFSA). It may be that the student will have to pay more of their college costs than if their money had been put in a 529 college savings account.

Is a CD a good investment for a child? That depends on the length of time between the opening of the CD account, and when the child reaches the age of majority. CDs don’t earn a lot of interest, and a growth-oriented investment might earn more and grow faster if the child is younger.

If the child is a teenager, a CD will provide a guaranteed amount of money, and there is no risk of loss if the market drops.

Where Can I Find a CD for a Child?

Most banks and credit unions offer CDs, and they allow custodians to open accounts for a child. Online banks can be convenient and secure. Many offer competitive interest rates and low fees. Be sure to compare the interest rates and APY of each bank and be sure to understand the penalties that will apply if you withdraw the funds early.

The Takeaway

There are many ways to help your child save. Which one is the best depends on the ultimate use of the funds. CDs are safe, they are federally insured up to $250,000, and they may offer higher interest rates than regular savings accounts. However, other options to consider are a 529 savings account if your child is headed to college, a Roth IRA, or even a trust fund.

CDs are easy to open; most banks and credit unions offer these products. They earn interest on the amount invested as long as the funds are not withdrawn before the CD’s term. If the custodian does withdraw funds before the maturity date, the bank will charge a penalty.

Most online banks also offer CDs, and any adult can open a custodial account online for a child; they do not have to be a family member. The child is named as the owner of the account, and they will assume management of the account when they reach adulthood according to state laws.

When you’re comparing rates on different accounts, don’t overlook SoFi’s online banking app. This new all-in-one account outdoes the competition with no account or overdraft fees and a competitive APY. And the new Checking and Savings is easy to manage from your phone or computer.

FAQ

What is the best way to save money for a child?

The best way to save money for a child depends on your goals. Some options include a savings account or a custodial CD, a 529 college savings account, a Roth IRA (for longer-term growth), or even a trust fund.

Can you buy a CD as a gift?

Yes. Under the Uniform Gifts to Minors Act (UGMA) any adult can gift a CD to a child.

Can I open a CD for my child?

Yes. Opening a CD account for a child is easy using a custodial account. The child will be named as the owner and you as the custodian. The owner (the child) will assume full legal ownership of the CD when they reach adulthood. The account cannot be given to anyone else but the named holder.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

SoFi® Checking and Savings is offered through SoFi Bank, N.A. ©2023 SoFi Bank, N.A. All rights reserved. Member FDIC. Equal Housing Lender.
The SoFi Bank Debit Mastercard® is issued by SoFi Bank, N.A., pursuant to license by Mastercard International Incorporated and can be used everywhere Mastercard is accepted. Mastercard is a registered trademark, and the circles design is a trademark of Mastercard International Incorporated.

SoFi members with direct deposit activity can earn 4.60% annual percentage yield (APY) on savings balances (including Vaults) and 0.50% APY on checking balances. Direct Deposit means a deposit to an account holder’s SoFi Checking or Savings account, including payroll, pension, or government payments (e.g., Social Security), made by the account holder’s employer, payroll or benefits provider or government agency (“Direct Deposit”) via the Automated Clearing House (“ACH”) Network during a 30-day Evaluation Period (as defined below). Deposits that are not from an employer or government agency, including but not limited to check deposits, peer-to-peer transfers (e.g., transfers from PayPal, Venmo, etc.), merchant transactions (e.g., transactions from PayPal, Stripe, Square, etc.), and bank ACH funds transfers and wire transfers from external accounts, do not constitute Direct Deposit activity. There is no minimum Direct Deposit amount required to qualify for the stated interest rate.

SoFi members with Qualifying Deposits can earn 4.60% APY on savings balances (including Vaults) and 0.50% APY on checking balances. Qualifying Deposits means one or more deposits that, in the aggregate, are equal to or greater than $5,000 to an account holder’s SoFi Checking and Savings account (“Qualifying Deposits”) during a 30-day Evaluation Period (as defined below). Qualifying Deposits only include those deposits from the following eligible sources: (i) ACH transfers, (ii) inbound wire transfers, (iii) peer-to-peer transfers (i.e., external transfers from PayPal, Venmo, etc. and internal peer-to-peer transfers from a SoFi account belonging to another account holder), (iv) check deposits, (v) instant funding to your SoFi Bank Debit Card, (vi) push payments to your SoFi Bank Debit Card, and (vii) cash deposits. Qualifying Deposits do not include: (i) transfers between an account holder’s Checking account, Savings account, and/or Vaults; (ii) interest payments; (iii) bonuses issued by SoFi Bank or its affiliates; or (iv) credits, reversals, and refunds from SoFi Bank, N.A. (“SoFi Bank”) or from a merchant.

SoFi Bank shall, in its sole discretion, assess each account holder’s Direct Deposit activity and Qualifying Deposits throughout each 30-Day Evaluation Period to determine the applicability of rates and may request additional documentation for verification of eligibility. The 30-Day Evaluation Period refers to the “Start Date” and “End Date” set forth on the APY Details page of your account, which comprises a period of 30 calendar days (the “30-Day Evaluation Period”). You can access the APY Details page at any time by logging into your SoFi account on the SoFi mobile app or SoFi website and selecting either (i) Banking > Savings > Current APY or (ii) Banking > Checking > Current APY. Upon receiving a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.60% APY on savings balances (including Vaults) and 0.50% on checking balances on or before the following calendar day. You will continue to earn these APYs for (i) the remainder of the current 30-Day Evaluation Period and through the end of the subsequent 30-Day Evaluation Period and (ii) any following 30-day Evaluation Periods during which SoFi Bank determines you to have Direct Deposit activity or $5,000 in Qualifying Deposits without interruption.

SoFi Bank reserves the right to grant a grace period to account holders following a change in Direct Deposit activity or Qualifying Deposits activity before adjusting rates. If SoFi Bank grants you a grace period, the dates for such grace period will be reflected on the APY Details page of your account. If SoFi Bank determines that you did not have Direct Deposit activity or $5,000 in Qualifying Deposits during the current 30-day Evaluation Period and, if applicable, the grace period, then you will begin earning the rates earned by account holders without either Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.

Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% APY on savings balances (including Vaults) and 0.50% APY on checking balances.

Interest rates are variable and subject to change at any time. These rates are current as of 10/24/2023. There is no minimum balance requirement. Additional information can be found at https://www.sofi.com/legal/banking-rate-sheet.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Photo credit: iStock/Hispanolistic
SOBK0422045

We work hard for our money, so it’s a nice change of pace when our money works hard for us, which is what a tiered-rate savings account can do.

Putting cash into any kind of savings account can help money grow, not only by keeping it separate from where we do our spending but by earning interest. One option that can be pretty appealing is a tiered-rate savings account. The interest rate that a tiered-rate savings account earns usually grows as the amount of savings increases — which can make stashing away cash even more motivating.

Learn more here, including:

•   What is a tiered interest rate?

•   How do tiered-rate savings accounts work?

•   What are the pros and cons of tiered-rate savings accounts?

•   What are alternatives to tiered-rate savings accounts?

What Is a Tiered-Rate Savings Account?

A tiered-rate account is a savings account that has more than one potential interest rate that can be applied. Usually, the interest rate for a savings account doesn’t vary depending on the amount in the account, though it may change based on prevailing market conditions. (However, since the point of savings vs. checking accounts is to earn some interest, a fixed rate can be perfectly fine).

The way these tiered-rate accounts generally work is that as someone’s savings grow, so does their interest rate. Interest rates are offered on a tiered scale with the largest balances getting the highest interest rates. The interest rates offered by these accounts are known as tiered interest rates or escalating interest rates.

The point of this financial product is to encourage customers to save more money as they work towards earning the highest possible interest rate. It also helps keep account holders loyal to their current bank if they are wondering, “Do I need long-term savings?” With a tiered-rate account, the answer may be yes since customers are rewarding for their continued saving.

How Do Tiered-Rate Savings Accounts Work?

Here’s a closer look at how a tiered interest rate and tiered interest-rate accounts work. As briefly noted above, with a tiered-rate account, the higher someone’s balance is, the higher their interest rate is likely to be. That means, as their balance grows, their interest rate has the potential to rise. This can make a person’s savings grow more quickly.

Tiered-rate accounts offer account holders different “tiered” interest rates that correspond with different account balances. For example, if Acme Bank offers a tiered-rate savings account they may give a 0.01% interest rate for savings account amounts ranging from $10,000 to $25,000. For savings ranging from $25,000 to $100,000 they may up that interest rate to 0.02%.

Tiered-rate savings accounts tend to have a minimum balance threshold in order to open an account for the first time. Typically, a minimum daily balance must also be maintained. These accounts may also require that their holders make a minimum amount of monthly transactions (which could involve deposits or transferring money to another account). This transaction minimum may exist to ensure that the bank earns enough from transaction fees to profit even when paying out a higher interest rate.

Characteristics of Tiered-Rate Accounts

The following characteristics are typically associated with tiered-rate accounts:

•   Interest rates rise as account balances grow

•   Minimum initial deposit and ongoing balance requirements

•   Minimum monthly transaction requirements

Pros of Tiered-Rate Savings Accounts

These are a few advantages typically associated with tiered-rate savings accounts.

Opportunity to Earn Higher Interest Rate on Savings

Tiered-rate savings accounts tend to offer higher interest rates than normal savings accounts do — especially for motivated savers who work to increase their account balances. (Incidentally, as you think about opening a new account, you may wonder whether opening a savings account affects your credit score. It typically does not; banks don’t usually pull a credit report in order to approve you.)

Potential for Money to Increase Quicker

Because interest rates can be higher with tiered-rate savings accounts, it’s possible for savings held in these accounts to grow faster than with other accounts (as long as the account holder doesn’t remove money from the account, that is). Thanks to compound interest, your money will make more money.

Recommended: How Does Compounding Interest Grow Your Money?

Cons of Tiered-Rate Savings Accounts

As to be expected, there are also some disadvantages associated with tiered-rate savings accounts that are worth keeping in mind.

Putting Money Elsewhere Can Be Better to Build Wealth

Yes, a tiered-rate account does offer the opportunity to earn interest on savings and to grow those savings. However, the interest rates offered by these types of accounts tend to deliver a lower return vs. other investments (such as investing in the stock market). While investing in stocks is riskier than earning interest in an insured savings account, consumers can potentially see much greater growth that way. This can be helpful when saving for long-term goals like retirement.

Need a Larger Account Balance for the Highest Rates

To secure the best interest rates through a tiered-rate savings account, consumers may need a very large sum of money held in their savings account. If someone doesn’t have that amount of money, they may find that a standard savings account actually performs better for them. They might also research which common bank account bonuses they could snag by opening one of these regular accounts.

Here at a glance is a chart comparing the pros and cons of tiered-rate accounts:

Alternatives to Tiered-Rate Savings Accounts

If someone is looking to earn money on their savings, there are a few different vehicles they can consider for earning interest on their funds.

•   High-yield savings accounts: High-yield savings accounts are similar to standard savings accounts, but they earn much higher interest rates. More often than not, high-yield savings accounts are found through online banks. These financial institutions can save big since they don’t have to finance bricks-and-mortar branch locations; they can pass along the savings to their customers in the form of higher interest rates, lower fees, and/or special bonuses.

•   Money market accounts: Money market accounts are typically insured by the Federal Deposit Insurance Corporation (FDIC) or National Credit Union Administration (NCUA) like a savings account, so they are very secure. They tend to have a higher APY than a normal savings account. There is, however, a potential downside: Money markets may have significantly higher minimum deposit and balance requirements, and they can also have withdrawal limits much like some savings accounts do.

•   Certificate of deposit: Certificates of deposit vs. savings accounts can be a wise choice for some consumers. Also known as CDs, certificates of deposit are time or term deposits, meaning the money stays in the account for a specific period of time (typically six months to a few years, though longer and shorter products are available). If you withdraw the funds before what is known as the maturity date, or the end of the term, you will likely pay a penalty fee. Because of the commitment to keep your money on deposit for a set length of time, CDs may offer higher interest rates than savings accounts and money market accounts.

The Takeaway

If someone has a chunk of money available to set aside, they may find that a tiered-rate savings account can be a good option. It offers them a way to earn a higher rate as they sock away more cash. If, however, someone is just starting their savings journey, a standard savings account with a single interest rate may work more in their favor. In all situations, the aspiring account holder needs to balance such variables as interest rate, minimum deposit and balance requirements, and account fees. By evaluating those factors, the right savings vehicle should come into focus.

Want to earn more interest on your savings? Check out what SoFi offers with Checking and Savings. When you open an online bank account with direct deposit, SoFi offers a competitive APY right off the bat, charges no account fees, and gives you access to a network of 55,000+ fee-free ATMs, all of which can help your money grow. Another perk: SoFi recently announced that deposits may be insured up to $2 million through participation in the SoFi Insured Deposit Program¹.

FAQ

What is tiered APY?

Tiered-rate accounts offer account holders different “tiered” interest rates (which can be expressed as an APY, or annual percentage yield). The amount an account holder has on deposit will qualify them for a certain interest rate “tier” or level. Typically, the more money on deposit, the higher your rate.

What is tiering in banking?

Tiering in banking refers to tiered-savings accounts, which provide account holders with different interest rates based on their savings account’s balance. Usually, the higher someone’s account balance is, the higher their interest rate is.

Is a tiered interest rate good?

A tiered interest-rate structure tends to benefit savers who have high account balances since the more money you have on deposit, the higher your interest rate. If someone has a smaller amount of savings, a standard or high-yield savings account with a single interest rate may be more advantageous to them.

¹SoFi Bank is a member FDIC and does not provide more than $250,000 of FDIC insurance per legal category of account ownership, as described in the FDIC’s regulations. Any additional FDIC insurance is provided by banks in the SoFi Insured Deposit Program. Deposits may be insured up to $2M through participation in the program. See full terms at SoFi.com/banking/fdic/terms. See list of participating banks at SoFi.com/banking/fdic/receivingbanks.

SoFi® Checking and Savings is offered through SoFi Bank, N.A. ©2023 SoFi Bank, N.A. All rights reserved. Member FDIC. Equal Housing Lender.
The SoFi Bank Debit Mastercard® is issued by SoFi Bank, N.A., pursuant to license by Mastercard International Incorporated and can be used everywhere Mastercard is accepted. Mastercard is a registered trademark, and the circles design is a trademark of Mastercard International Incorporated.

SoFi members with direct deposit activity can earn 4.60% annual percentage yield (APY) on savings balances (including Vaults) and 0.50% APY on checking balances. Direct Deposit means a deposit to an account holder’s SoFi Checking or Savings account, including payroll, pension, or government payments (e.g., Social Security), made by the account holder’s employer, payroll or benefits provider or government agency (“Direct Deposit”) via the Automated Clearing House (“ACH”) Network during a 30-day Evaluation Period (as defined below). Deposits that are not from an employer or government agency, including but not limited to check deposits, peer-to-peer transfers (e.g., transfers from PayPal, Venmo, etc.), merchant transactions (e.g., transactions from PayPal, Stripe, Square, etc.), and bank ACH funds transfers and wire transfers from external accounts, do not constitute Direct Deposit activity. There is no minimum Direct Deposit amount required to qualify for the stated interest rate.

SoFi members with Qualifying Deposits can earn 4.60% APY on savings balances (including Vaults) and 0.50% APY on checking balances. Qualifying Deposits means one or more deposits that, in the aggregate, are equal to or greater than $5,000 to an account holder’s SoFi Checking and Savings account (“Qualifying Deposits”) during a 30-day Evaluation Period (as defined below). Qualifying Deposits only include those deposits from the following eligible sources: (i) ACH transfers, (ii) inbound wire transfers, (iii) peer-to-peer transfers (i.e., external transfers from PayPal, Venmo, etc. and internal peer-to-peer transfers from a SoFi account belonging to another account holder), (iv) check deposits, (v) instant funding to your SoFi Bank Debit Card, (vi) push payments to your SoFi Bank Debit Card, and (vii) cash deposits. Qualifying Deposits do not include: (i) transfers between an account holder’s Checking account, Savings account, and/or Vaults; (ii) interest payments; (iii) bonuses issued by SoFi Bank or its affiliates; or (iv) credits, reversals, and refunds from SoFi Bank, N.A. (“SoFi Bank”) or from a merchant.

SoFi Bank shall, in its sole discretion, assess each account holder’s Direct Deposit activity and Qualifying Deposits throughout each 30-Day Evaluation Period to determine the applicability of rates and may request additional documentation for verification of eligibility. The 30-Day Evaluation Period refers to the “Start Date” and “End Date” set forth on the APY Details page of your account, which comprises a period of 30 calendar days (the “30-Day Evaluation Period”). You can access the APY Details page at any time by logging into your SoFi account on the SoFi mobile app or SoFi website and selecting either (i) Banking > Savings > Current APY or (ii) Banking > Checking > Current APY. Upon receiving a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.60% APY on savings balances (including Vaults) and 0.50% on checking balances on or before the following calendar day. You will continue to earn these APYs for (i) the remainder of the current 30-Day Evaluation Period and through the end of the subsequent 30-Day Evaluation Period and (ii) any following 30-day Evaluation Periods during which SoFi Bank determines you to have Direct Deposit activity or $5,000 in Qualifying Deposits without interruption.

SoFi Bank reserves the right to grant a grace period to account holders following a change in Direct Deposit activity or Qualifying Deposits activity before adjusting rates. If SoFi Bank grants you a grace period, the dates for such grace period will be reflected on the APY Details page of your account. If SoFi Bank determines that you did not have Direct Deposit activity or $5,000 in Qualifying Deposits during the current 30-day Evaluation Period and, if applicable, the grace period, then you will begin earning the rates earned by account holders without either Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.

Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% APY on savings balances (including Vaults) and 0.50% APY on checking balances.

Interest rates are variable and subject to change at any time. These rates are current as of 10/24/2023. There is no minimum balance requirement. Additional information can be found at https://www.sofi.com/legal/banking-rate-sheet.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

SOBK0522008

Portfolio diversification involves investing your money across a range of different asset classes — such as stocks, bonds, and real estate — rather than concentrating all of it in one area. Studies have shown that by diversifying the assets in your portfolio, you may offset a certain amount of investment risk and thereby improve returns.

Taking portfolio diversification to the next step — further differentiating the investments you have within asset classes (for example, holding small-, medium-, and large-cap stocks, or a variety of bonds) — may also be beneficial.

Building a diversified portfolio is only one of many financial tools that can help mitigate investment risk and improve performance. But there is a lot of research behind this strategy, so it’s a good idea to understand how it works and how it might benefit your financial plan.

What Is Portfolio Diversification and Why Does It Matter?

When you invest in stocks and other securities, you may be tempted to invest your money in a handful of sectors or companies where you feel comfortable. You might justify this approach because you’ve done your due diligence, and you feel confident about those sectors or companies. But rather than protecting your money, limiting your portfolio like this could make you more vulnerable to losses.

To understand this important aspect of portfolio management, it helps to know about the two main types of risk.

•   Systematic risk, or market risk, is caused by widespread events like inflation, geopolitical instability, interest rate changes, or even pandemics like Covid. You can’t manage systematic risk through diversification, though; it’s part of the investing landscape.

•   Unsystematic risk is unique or idiosyncratic to a particular company, industry, or place. Let’s say, for example, a CEO is implicated in a corruption scandal, sending their company’s stock plummeting; or extreme weather threatens a particular crop, putting a drag on prices in that sector. This is unsystematic risk.

While investors can’t do much about systematic risk, portfolio diversification can help mitigate unsystematic risk. That’s because even if one investment is hit by a certain negative event, another holding could remain relatively stable. So while you might see a dip in part of your portfolio, other sectors can act as ballast to keep returns steady. This is why diversification matters.

You can’t protect against the possibility of loss completely — after all, risk is inherent in investing. But building a portfolio that’s well diversified helps reduce your risk exposure because your money is distributed across areas that aren’t likely to react in the same way to the same occurrence.

A Look at How to Build a Diversified Portfolio

You may have heard of the 60-40 rule, which is a basic rule-of-thumb for asset allocation: You invest 60% of your portfolio in equities and 40% in fixed income and cash. The formula varies according to your age, investment objectives, and/or risk tolerance. But this model reflects the basic principles of diversification: By investing part of your portfolio in equities and part in bonds/fixed income, you can manage some of the risk that can come with being invested in equities.

If you’re invested 100% in equities, for example, you’re more vulnerable to a market downturn that’s due to systematic risk, as well as shocks that come from unsystematic risk. By balancing your portfolio with bonds, say, which usually react differently than stocks to market volatility, you can offset part of that downside.

Of course, that also means that when the market goes up, you likely wouldn’t see the same gains as you would if your portfolio were 100% in equities.

By the same token, if your portfolio is invested 100% in bonds, you might be shielded from certain risk factors that plague equities, but you likely wouldn’t get as much growth either.

A 60-40 portfolio is an example of simple diversification (sometimes called naive diversification) — which means investing in a range of asset classes. Proper diversification would have you go deeper, and invest in several different stocks (domestic, international, tech, health care, and so on), as well as an assortment of fixed income instruments.

3 Tips for Building a Diversified Portfolio

To attain a diversified portfolio, it’s important to think through your asset allocation, based on your available capital and risk tolerance. It’s also important to spread investments out within each asset class.

Invest in a Range of Stocks or an Index Fund

Diversifying a stock portfolio requires thinking about a number of factors, including quantity, sector, the risk profile of different companies, and so on.

•   Quantity. Instead of owning shares of just one company, a portfolio may have a margin of protection when it’s invested in many stocks (perhaps dozens or even hundreds).

•   Sector. You may want to think about a range of sectors, e.g. consumer goods, sustainable energy, agriculture, energy, and so on.

•   Variety in the types of stocks you are selecting is also an important factor. A mix of small-, mid-, and large-cap companies can be valuable.

   You can further diversify by style. Some investors may opt for a mix of cyclical versus defensive companies, those closely tied to economic growth cycles versus ones that aren’t. Some investors may prefer value vs. growth stocks, companies that are underpriced rather than those that demonstrate faster revenue or earnings growth.

One common way to diversify a stock portfolio is to avoid picking individual stocks and invest instead in a mutual fund or ETF that offers exposure to dozens of companies or more. This is known as passive investing, as opposed to active. But it can be an effective way to add diversification.

💡 Recommended: Active vs Passive Investing: Differences Explained

Invest in Fixed Income

Bonds are a good way to diversify your portfolio because they perform very differently from stocks. Bonds tend to be less risky than stocks, but they aren’t risk free. They can be subject to default risk or call risk — and can also be subject to market volatility, especially when rates rise or fall. But bonds generally move in the opposite direction from stocks, and so can serve to counterbalance the risk associated with a stock portfolio.

Also, though bond yields can be lower than the return on some stocks, you generally can predict the amount you’ll get from bond investments.

Instead of being subject to market volatility, with bonds you know exactly how much you will receive and when. Your returns are likely to be lower, but bonds can.

You can diversify your mix of bonds, as well. High-yield bonds offer higher interest rates, but have a greater risk of default from the borrower. Short-term Treasury bonds, on the other hand, tend to be safer, but the return on investment isn’t as high.

You can consider green bonds, which typically invest in sustainable organizations or municipal projects, as well as municipal bonds, which can offer tax benefits. And you can expand your options, and create more diversification, when you invest in bond mutual funds, or exchange-traded bond funds.

Consider Investing in Real Estate

The housing market and equity market can influence each other — case in point: the 2008 recession, when widespread troubles in real estate led to a stock market crash. But they don’t always have such a strong relationship. When stocks or bonds drop, real estate prices can take much longer to follow.

Conversely, when the markets improve, housing can take a while to catch up. Also, every real estate market is different. Location-specific factors that have nothing to do with the broader economy can cause prices to soar or plummet.

These are all factors to consider when investing in real estate. In addition, there are different types of investments, like Real Estate Investment Trusts or REITs, which can provide access to certain markets.

How Portfolio Diversification May Protect Your Nest Egg

Although creating a well-diversified portfolio may help improve performance, the real aim is to minimize the impact of unwanted or unforeseen risk factors on your nest egg. To that end, researchers have run countless portfolio simulations, based on historic market data, to test the outcome of different asset allocation strategies.

Of course past performance is no guarantee that outcomes of those portfolio allocations will be the same in the future. But the research is interesting in that it suggests certain strategies might be effective in mitigating risk. For example, an all-stock portfolio tends to have an historic return that’s similar to the stock market return on average: about 9%.

But the highest and lowest returns for certain years might be difficult for some investors to stomach.

Introducing greater diversification, by way of bonds and fixed income instruments, actually can create a portfolio with similar returns, but lower volatility over time. The more low-risk investments enter the picture, the lower the overall return tends to be, but so is the amount of volatility.

Other Ways to Diversify Your Investments

While stocks, real estate, and bonds are among the most common investments, you can diversify your portfolio by putting money into alternative investments, including assets you think will accumulate value over time. For example, some people invest in art, wine, cars, or even non-fungible tokens (NFTs). Of course, knowing something about the area you want to invest in, or consulting experts, is a smart idea before you get started.

Interested in alts? Check out our guide: What Are Alternative Investments?.

Another possibility is to opt for low-risk short-term investments, such as certificates of deposit (CDs). A CD is a savings account that requires you to keep your funds locked up for a set amount of time (typically a few months to a few years), in exchange it pays you a fixed interest rate that may be higher than a traditional savings account.

A diversification strategy can also involve holding some funds in cash, just in case the bottom falls out on other investments.

Another strategy for diversification is to invest in both U.S. and foreign stocks. Spreading out your investments geographically might protect you from market volatility concentrated in one area. When one region is in recession, you may still have holdings in places that are booming. Also, emerging and developed markets have different dynamics, so investing in both can potentially leave you with less overall risk.

The Takeaway

Portfolio diversification is one of the key tenets of long-term investing. Instead of putting all your money into one investment or a single asset class like stocks or bonds, diversification spreads your money out across a range of securities. Investors should make sure they vary their investments in a way that matches their goals and tolerance for risk.

If you’re ready to build your own diversified portfolio, you’ve come to the right place. When you open a brokerage account with SoFi Invest, you can buy and sell stocks, ETFs, IPO shares, fractional shares, and more. Trading is easy using SoFi’s secure app on your phone or computer. And SoFi members have access to complimentary financial advice from professionals.

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Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at [email protected]. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

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