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Why Portfolio Diversification Matters

March 03, 2021 · 5 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

Why Portfolio Diversification Matters

Based on the numbers, Americans seem to love investing. About 55% own a stock, whether it’s through retirement accounts, mutual funds, or individual portfolios, a Gallup survey conducted in 2020 shows. Meanwhile, about 66% own real estate, according to government figures.

But that doesn’t mean Americans always feel sure about what they’re doing. Investing is often complex and stressful, and it’s not like the basics concepts are thoroughly taught in school. According to an October 2020 survey , 55% of investors with no financial advisor felt “somewhat confident” that they had the best possible investment strategy, while another 25% were “not too confident.”

A financial advisor can certainly give you guidance, but even individual investors at home should always have an idea of where their money is and whether it’s deployed in ways that align with their goals.

Many people find learning about investing to be intimidating. But you don’t need to get a Ph.D. in finance to grasp the fundamentals of portfolio building.

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 or exchange-traded fund (ETF) that holds a variety of stocks tied to a certain index, such as the S&P 500.

Meanwhile, if you invest in real estate, diversifying means buying properties of varying types or in different markets, rather than just one type in a single location, like say all commercial real estate in one city, or all condos in one neighborhood.

The greater the quantity and variety of assets you own, the more diversified your portfolio is.

Why Diversification Strengthens a 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 widespread events like inflation, geopolitical instability or even worldwide pandemics like the Covid-19 virus.

Unsystematic risk is unique or idiosyncratic to a particular company, industry, or place. Let’s say hypothetically, 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. That’s because even if one investment plummets, another holding could remain relatively stable.

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.

How to Diversify an Investment Portfolio

To attain a diversified portfolio, it’s important to partake in asset allocation, or invest in a variety asset classes, based on your available capital and risk tolerance.

It’s also important to spread investments out within each asset class.

Stocks

Stocks are the most common investment vehicle and one famous for its volatility. Diversifying a stock portfolio starts with quantity. Instead of owning shares of just one company, a portfolio is more insulated when it’s invested in several dozen stocks, or even several hundreds or thousands, depending on the investor’s capabilities.

Variety in the types of stocks you are selecting is also an important factor. Some investors may opt for a mix of cyclical versus defensive companies, ones 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 gives exposure to stocks in a variety of companies. This is known as passive investing as opposed to active.

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 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 some 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 alternative investment funds or 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.

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.

The Takeaway

Portfolio diversification is one of the key principles of successful investing. Instead of betting the farm on one investment, diversification spreads your money out across stocks, bonds, real estate, and beyond. Investors should make sure they vary their investments in a way that matches their goals and tolerance for risk.

With SoFi Invest, users can diversify their holdings by putting money into stocks, ETFs or fractions of whole shares. Individuals can trade without commission fees on the Active Investing platform, or they can have their money managed for them with no SoFi management fees with the Automated Investing service.

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