Portfolio Diversification: What It Is and Why It's Important

Portfolio diversification involves investing money across a range of different asset classes — such as stocks, bonds, and real estate — rather than concentrating all of it in one asset class. The idea is that by diversifying the assets in your portfolio, an investor may potentially offset a certain amount of investment risk.

Building a diversified portfolio is one financial strategy an investor might use. Read on to learn how it works, why it’s important to diversify investments, and how it might fit into an individual’s financial plan.

What Is Portfolio Diversification

Portfolio diversification refers to spreading the investments in a portfolio across different asset classes, industries, company sizes, sectors, and more, in an effort to potentially reduce investment risk.

To understand this aspect of portfolio management, it helps to know about the two main types of risk: systemic risk and unsystematic risk.

•   Systematic risk, or market risk, is caused by widespread events like inflation, geopolitical instability, interest rate changes, or even public health crises. Investors can’t manage systematic risk through diversification, however; it’s part of the investing landscape.

•   Unsystematic risk is unique to a particular company, industry, or place. Let’s say, for example, extreme weather threatens a particular crop, causing prices in that sector to drop. This is an unsystematic risk.

While investors typically can’t do much about systematic risk, portfolio diversification might help with unsystematic risk. That’s because if an investor has different holdings, even if one asset or sector is hit by a negative event, others could remain relatively stable. So while they might see a dip in part of their portfolio, other sectors could act as balance to keep returns steady.

It’s impossible to completely protect against the possibility of loss — risk is inherent in investing. But building a portfolio that’s well diversified may help reduce some risk exposure because an investor’s money is distributed across areas that aren’t as likely to react in the same way to the same occurrence.


💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

Why Is It Important to Diversify Your Investments?

Diversification potentially benefits investors on several levels when trading stocks and other investments. Diversification spreads money across different investments in a portfolio. That way, if one investment loses value, other investments might help offset the losses and balance things out.

Diversification may also potentially help build wealth over the long-term.

The Role of Diversification in Managing Risk

Every portfolio carries some degree of risk. Diversification may help manage that risk to some degree.

How diversification may strengthen an investor’s portfolio begins with balancing the individual’s risk tolerance against their risk capacity.

Risk tolerance is the amount of risk an investor feels comfortable with. Risk capacity is the level of risk they need to take to meet their investment goals. Too much risk could set an investor up for potential losses, while taking too little risk could mean missing out on investment growth.

Here are some of the key areas where diversification plays a role in risk management.

•   Asset mix. Including a mix of assets in a portfolio allows investors to avoid the mistake of putting all their eggs in one basket. The idea is that if one area of their portfolio underperforms, their other investments might help balance things out.

•   Geographic variation. Investing in both domestic and international markets may help investors tap into market trends across borders. While one country’s economy might not be doing well, another may be thriving. Diversifying geographically could be a way to help manage risks associated with location-specific downturns.

•   Stabilization. Diversification may help with volatility if the market gets bumpy. For example, holding assets that have varying levels of correlation to stocks may offer some insulation against broad pricing swings or more sustained downturns. Bonds, for instance, typically have low correlation to stocks. By owning both, a portfolio may potentially experience more stability and less volatility.

Taking a risk tolerance quiz can help to determine an individual’s risk tolerance. An investor can then consider what kind of risk capacity they’ll need to help reach their long-term goals.

Those that favor a conservative investing approach might choose investments such as bonds, blue chip stocks, and cash equivalents. Investors that are comfortable with a more aggressive approach may opt for a mix of growth-focused investments that are higher risk, but may have a higher potential reward.

How to Build a Diversified Portfolio: 5 Key Asset Classes

To build a diversified portfolio, an investor can think about asset allocation, based on available capital, risk tolerance, and time horizon (meaning the amount of time they have to invest) and spreading out investments within each asset class. Here are five options to consider.

1. Domestic Stocks (U.S. Equities)

Domestic stocks are shares in companies that operate in the country in which an investor lives. Examples of U.S. domestic stocks include Apple, Google, and Costco.

Investing in domestic equities can be convenient, since an investor can buy shares on a public stock exchange. And they may already be familiar with a company’s products or services.

Owning individual stocks does have risks, however. Another option is to invest in ETFs. An ETF (exchange-traded fund) offers exposure to multiple stocks, bonds, and other investments in a single basket. Unlike traditional mutual funds, ETFs trade on a stock exchange like stocks and tend to be more cost-effective.

2. International Stocks (Global Equities)

Global equities are stocks from companies that operate outside an investor’s home country. Adding international stocks to a portfolio may potentially help with diversification since markets and economies don’t always move in the same direction at once.

Established markets may offer stability and predictability. Emerging markets might yield the potential for higher growth. But both have risks that are important to weigh.

With established markets, for example, there could be a ripple effect that when one country experiences a marked shift that creates shifts in other markets. A downturn in the U.S. stock market, for instance, could trigger price drops in European or Asian stock exchanges. Emerging countries, meanwhile, may be more susceptible to political instability or currency risk.

3. Bonds and Other Fixed-Income Assets

Bonds are issued by corporations and government entities. When an individual invests in a bond, they’re essentially giving the bond issuer a loan. In exchange, the issuer agrees to pay them a set interest rate on the money.

Bonds are a type of fixed-income investment, since they’re designed to provide predictable income to investors. Treasury bills, Treasury Inflation Protected Securities (TIPS), and mortgage-backed securities (MBS) are other examples of fixed-income investments.

Including bonds and other fixed-income options in a portfolio may help with diversification. These assets are typically considered to be lower risk than stocks. However, that doesn’t mean returns on bonds are guaranteed. It’s possible to lose money in bonds if the issuer defaults, for example.

4. Real Estate (e.g., REITs)

Real estate is another asset some investors might consider. Real estate investment trusts (REITs) and/or real estate ETFs are one way to invest in property without the hands-on requirements of ownership.

A REIT is a legal entity that owns and operates rental properties. REITs may own a single type of property or several. Some common REIT property types include:

•   Apartment buildings

•   Student housing

•   Healthcare facilities

•   Office space

•   Retail space

•   Storage space

•   Warehouse space

REITS are required to pay out 90% of their taxable income to shareholders as dividends. Real estate ETFs primarily invest in REITs, but they can hold other real estate-related investments as well.

5. Alternative Investments and Commodities

Alternative investments are investments that are not traditional asset classes such as stocks or bonds. Examples of alternative investments include:

•   Fine art

•   Fine wines

•   Antique or collectible cars

•   Private equity

•   Private credit

Commodities like oil, what, or gain, are also a type of alternative investment.

Alternative investments may offer the possibility of higher returns, but they’re highly risky and speculative.

What Does a Diversified Portfolio Look Like? (Examples)

A diversified portfolio example can help an investor visualize how their investments might pay off over time. For instance, the 60-40 rule is one basic rule of thumb for asset allocation. With this strategy, an individual invests 60% of their portfolio in equities and 40% in fixed income and cash. Here’s what that method looks like.

That’s just one example. A portfolio can contain a broader mix of assets that includes stocks, bonds, alternative assets, REITs, and much more.

An investor’s risk tolerance also typically influences what their portfolio might look like. Here are some examples of conservative, moderate, and aggressive portfolios.

Example of a Conservative Portfolio

A conservative portfolio might generally have a higher proportion of bonds, fixed-income, and cash investments compared to stocks. It might look something like this:

•   30% stocks

•   60% bonds

•   10% cash

This type of portfolio typically carries a lower degree of risk, but it may limit growth potential.

Example of a Moderate Portfolio

The 60/40 portfolio described above is an example of what a model portfolio might look like. An investor with a moderate portfolio might also choose a different mix or percentage of stocks and bonds, tailored to their needs and risk tolerance.

For instance, that might look like:

•   50/50 split, with half the money in stocks and half in bonds/fixed-income

•   70/30 split, with more devoted to stocks and less invested in bonds

Moderate portfolios aim to find a balance between riskier investments that can deliver growth, and safer, more stable holdings.

Example of an Aggressive Portfolio

An aggressive portfolio is typically more heavily weighted toward stocks. For example, such a portfolio may be composed of:

•   85% stocks

•   10% bonds/fixed-income

•   5% cash

This is the type of portfolio that may be preferred by those who are comfortable taking on more risk in exchange for a chance to potentially earn higher returns.

The Easiest Ways to Start Diversifying

When an investor is ready to start diversifying their portfolio, there are a couple of options they might want to consider to help simplify the process.

Using All-in-One ETFs or Mutual Funds

ETFs and mutual funds are a collection of multiple investments. Rather than choosing stocks or bonds individually, with an ETF or mutual fund an investor could invest in several of them all at once. ETFs are traded like stocks, while mutual funds settle once a day at the close of the market. Both assets carry expense ratios, which determine the annual cost of owning the fund.

An index fund is a type of mutual fund that attempts to mimic the performance of a specific stock index. For example, there are funds that track the S&P 500. In this case, how well the fund performs is ultimately tied to the movements of its underlying index.

Knowing the underlying investments in ETFs or mutual funds might help prevent overweighting the asset allocation, which could happen if an individual invests in multiple funds that hold the same kind of investments.

Using an Automated Investing Service

Another option some investors might want to consider is using a robo-advisor to do portfolio diversification. With an automated investing platform, individuals can typically get a customized portfolio that’s tailored to their age, risk tolerance, and goals.

In addition, automatic rebalancing may help investors maintain the appropriate level of diversification. Rebalancing means buying and selling assets to keep the allocation aligned with an investor’s original targets.

Automated investing is not for everyone, and it may have limitations such as less control and fewer choices. However, some investors might find it to be a convenient way to diversify without being completely hands-on.

What Are the Main Pros and Cons of Diversification?

Diversification offers advantages and disadvantages for investors to consider. Here are two specific factors to keep in mind.

Advantage: Smoothing Out a Portfolio’s Returns

One potential benefit of diversification is that it may help reduce an investor’s overall level of risk. It may possibly create a smoother experience for investors during times of market volatility by providing balance through different asset classes, sectors, and regions.

Disadvantage: Potentially Limiting Your Upside

A possible drawback to diversification includes the fact that returns may be limited by a more risk-averse approach. Also, diversification does not help protect against all risk, especially market-specific risk. And diversification does not eliminate risk.

The Takeaway

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

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FAQ

What is an example of a well-diversified portfolio?

An example of a well-diversified portfolio is one that fits an investor’s financial situation, goals, risk tolerance, and time horizon. For example, a conservative portfolio might have 30% stocks, 60% bonds, and 10% cash. A moderate portfolio may contain a 50%-50% split of stocks and fixed assets including bonds. And an aggressive portfolio might have 85% stocks, 10% fixed assets, and 5% cash. But again, these are just examples.

What are the dangers of over-diversifying your portfolio?

An over-diversified portfolio might lead to owning too many similar or overlapping investments, such as too many mutual funds that are similar in terms of their holdings. Over-diversification may also reduce a portfolio’s returns without meaningfully reducing risk.

When should you diversify your portfolio?

While there is no one right answer to when to diversify, an investor might decide to diversify their portfolio as soon as they start investing, for example. They might spread out their investment over different asset classes, industries, company sizes, sectors, regions, and so on. Investors can check their asset allocation at regular intervals to make sure they are properly diversified in accordance with their risk tolerance, time horizon, and goals.

Does diversification guarantee I won’t lose money?

No. Diversification is not a guarantee that you won’t lose money. Investing is inherently risky, and there is no strategy that eliminates the risk. A diversified portfolio might offer a way to help manage some risk, but it cannot eliminate risk.

How many stocks should I own to be diversified?

There’s no specific number of stocks an investor should own to be diversified. How many stocks an individual chooses to hold can depend on their risk tolerance, investment style, goals, and time horizon among other factors.

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