An Investor’s Guide To Diversification
Diversification is an investing strategy that helps reduce risk by allocating investments across various financial assets. Here’s everything you need to know.
In 1 minute
When you invest too heavily in a single asset, type of asset, or market, your portfolio is more exposed to the risks that come with it. That’s why investors diversify.
Diversification means spreading your investments across multiple assets, asset classes, or markets.
This aims to do two things:
- Limit your exposure to specific risks
- Make your performance more consistent
As the market fluctuates, a diverse portfolio generally remains stable. Extreme losses from one asset have less impact—because that asset doesn’t represent your entire portfolio.
Maintaining a diversified portfolio forces you to see each asset in relation to the others. Is this asset increasing your exposure to a particular risk? Are you leaning too heavily on one company, industry, asset class, or market?
In 5 minutes
In this guide, we’ll:
- Define diversification
- Explain the benefits of diversification
- Discuss the potential disadvantages of diversification
What is diversification?
Financial assets gain or lose value based on different factors. Stocks depend on companies’ performance. Bonds depend on the borrower’s (companies, governments, etc.) ability to pay back loans. Commodities depend on public goods. Real estate depends on property. Entire industries can rise or fall based on government activity.
What’s good or bad for one asset may have no effect on another.
If you only invest in stocks, your portfolio’s value completely depends on the performance of the companies you invest in. With bonds, changing interest rates or loan defaults could hurt you. And commodities are directly tied to supply and demand.
Diversification works to spread your investments across a variety of assets and asset classes, so no single weakness becomes your fatal flaw. The more unrelated your assets, the more diverse your portfolio.
So you might invest in some stocks. Some bonds. Some fund commodities. And then if one company has a bad quarterly report, gets negative press, or even goes bankrupt, it won’t tank your entire portfolio.
You can make your portfolio more diverse by investing in different assets of the same type—like buying stocks from separate companies. Better yet: companies in separate industries. You can even invest internationally, since foreign markets can potentially be less affected by local downturns.
What are the benefits of diversification?
There are two main reasons to diversify your portfolio:
- It can help reduce risk
- It can provide more consistent performance
Here’s how it works.
Each type of financial asset comes with its own risks. The more you invest in a particular asset, the more vulnerable you are to its risks. Put everything into bonds, for example? Better hope interest rates hold.
Distributing your assets distributes your risk. With a diversified portfolio, there are more factors that can negatively affect your performance, but they affect a smaller percentage of your portfolio, so your overall risk is much lower.
If 100% of your investments are in a single company and it goes under, your portfolio tanks. But if only 10% of your investments are in that company? The same problem just got a whole lot smaller.
The more assets you invest in, the less impact each one has on your portfolio. If your assets are unrelated, their gains and losses depend on different factors, so their performance is unrelated, too. When one loses value, that loss is mitigated by the other assets. And since they’re unrelated, some of your other assets may even increase in value at the same time.
Watch the value of a single stock or commodity over time, and you’ll see its value fluctuate significantly. But watch two unrelated stocks or commodities—or one of each—and their collective value fluctuates less. They can offset each other.
Diversification can make your portfolio performance less volatile. The gains and losses are smaller, and more predictable.
Potential disadvantages of diversification
While the benefits are clear, diversification can have a couple drawbacks:
- It creates a ceiling on potential short-term gains
- Diverse portfolios may require more maintenance
Limits short-term gains
Diversification usually means saying goodbye to extremes. Reducing your risk also reduces your potential for extreme short-term gains. Investing heavily in a single asset can mean you’ll see bigger gains over a short period.
For some, this is the thrill of investing. With the right research, the right stock, and the right timing, you can strike it rich.
But that’s not how it usually goes.
Diversification is about playing the long game. You’re trading the all-or-nothing outcomes you can get with a single asset for steady, moderate returns.
May require more maintenance
As you buy and sell financial assets, diversification requires you (or a broker) to consider how each change affects your portfolio’s diversity. If you sell all of one asset and re-invest in another you already have, you increase the overall risk of your portfolio.
Maintaining a diversified portfolio adds another layer to the decision-making process. You have to think about each piece in relation to the whole. A robo advisor or broker can do this for you, but if you’re managing your own portfolio, diversification may take a little more work.