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Understanding Portfolio Diversification

By MP Dunleavey · June 17, 2022 · 7 minute read

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Understanding Portfolio Diversification

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.

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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The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
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