Why Portfolio Diversification Matters

August 29, 2018 · 5 minute read

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Why Portfolio Diversification Matters

Based on the numbers, Americans seem to love investing. More than half have bought into the stock market, whether through retirement accounts, mutual funds, or individual stocks. And 64% own real estate .

But that doesn’t mean we know what we’re doing. Investing is often complicated, and most of us didn’t learn even the basic concepts at school. According to a recent survey, 42% of investors don’t even know how the assets in their retirement portfolios are allocated. Considering that their future depends on it, ignorance is not a winning strategy.

A financial advisor can certainly give you guidance, but you should always have an idea of where your money is and whether it’s deployed in ways that align with your goals. Many people find learning about investing to be intimidating. But you don’t need to get a Ph.D. in finance to gain the basic financial literacy that will give you peace of mind.

What is a Diversified Portfolio?

Portfolio diversification involves spreading your money across different asset classes—such as stocks, bonds, and real estate—rather than concentrating all of it in one area. It also involves diversifying how you allocate your money within each sector.

For example, instead of buying stock in an individual company, you would invest in an index fund, which is a type of mutual fund that holds a variety of stocks tracked to a certain index, such as the S&P 500. If you invest in real estate, diversifying means buying property of different types in different markets, rather than just one type in a single location. The greater the quantity and variety of assets you own, the more diversified your portfolio is.

How Does Diversification Strengthen An Investor’s Portfolio?

It may be tempting to concentrate your money in a few familiar sectors or in companies for which you have a personal affinity. But putting all your eggs in one basket makes you vulnerable. There are two primary types of risk: Systematic risk, caused by things like inflation or war, affects most companies and economic sectors equally.

Unsystematic risk is unique to a particular company, industry, or place (for example, a CEO is implicated in a corruption scandal, sending a corporation’s stock plummeting, or new regulations pass that threaten the future of a certain industry in one country). While investors can’t do much about systematic risk, portfolio diversification helps mitigate unsystematic risk.

You can’t guarantee against the possibility of loss completely—after all, risk is inherent in investing. But spreading your assets out reduces your vulnerability because your money is distributed across areas that aren’t likely to react in the same way to the same occurrence.

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How to Diversify Your Investment Portfolio

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

Stocks

Stocks are the most common investment vehicle and one of the most volatile. Diversifying a stock portfolio starts with quantity. Instead of owning stock in just one company, a portfolio is is more insulated when it’s invested in several dozen, or even several hundred or thousand. Variety in the types of stocks you are selecting, is also an important factor.

One common way to diversify a stock portfolio is to avoid picking individual stocks and invest instead in a mutual fund or exchange-traded fund comprised of stocks in a variety of companies.

Real Estate

The housing market and stock market can influence each other—case in point: the 2008 recession—but they don’t have a strong relationship. When stocks or bonds drop, real estate prices usually take much longer to follow.

Conversely, when stock 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. Real estate investments have outperformed the stock market in many areas around the country in recent years, particularly in expensive markets like Silicon Valley.

Bonds

Governments and corporations issue bonds when they want to raise money. As an investor, you are lending the issuer a fixed amount of money for a fixed amount of time and charging interest, which can be fixed or variable.

The borrower must repay the entire value of the bond by its maturity date. Bonds are a good way to diversify your portfolio because they perform very differently from stocks. Instead of being subject to market volatility, with bonds you know exactly how much you will receive and when until the bond reaches maturity. Your returns are likely to be lower, but bonds are a secure investment that can counterbalance the risk associated with an aggressive stock portfolio.

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.

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 anything that you think will accumulate value over time. For example, people invest in art, wine, or cars. Of course, knowing something about the area you want to invest in, or consulting experts, is a smart idea before you get started.

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 in it for a fixed amount of time and allows you to earn a fixed interest rate along the way. A diversification strategy can also involve holding some funds in cash, just in case the bottom falls out on other investments.

Investing in Both Domestic and International Stocks

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’ll still have holdings in places that are booming. Also, emerging and developed markets have different dynamics, so investing in both can potentially leave you less exposed.

Portfolio diversification is one of the key principles of successful investing. Instead of betting the farm on one investment, diversification spreads you money out—across stocks, bonds, real estate, and beyond—in a way that matches your goals and tolerance for risk.

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SoFi can’t guarantee future financial performance.
This information isn’t financial advice. Investment decisions should be based on specific financial needs, goals and risk appetite.
Diversification can help reduce some investment risk. It cannot guarantee profit or protect against loss in a declining market.
SoFi doesn’t provide tax or legal advice. Individual circumstances are unique. Consult with a qualified tax advisor or attorney.
The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Advisory services offered through SoFi Wealth, LLC, a registered investment advisor.

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