Why Diversification Is Important to Your Portfolio
As the manager of your portfolio, you need to understand the importance of diversification. Despite your wish that all your positions will soar, there will be periods when some of your holdings will lose money. When that occurs, you need other investments to offset the decline. Diversification ensures that by not "putting all your eggs in one basket," you will not be creating an unwanted risk to your capital. Diversifying your stock portfolio is important because it keeps any part of your investment assets from being too heavily weighted toward one company or sector.
Many investors diversify by buying different types of funds. Advisors recommend beginning with a broad-based index fund that merely tries to mirror the performance of the S&P 500. You can then complement that index fund with a few different ones of varying risk levels. These could include funds that:
- Purchase shares in overseas companies
- Consist of shares of small growth companies
- Invest in bonds
- Buy shares in real estate investment trusts (REITs)
Each of these fund types performs differently under different market conditions. When you spread your investments across them, you make it more likely that you always have some stocks performing well at any given time.
At websites such as Morningstar, you can find analysis and information about mutual funds to get you started. Brokerages will also typically offer what is called a fund "prospectus," which any company that offers a stock or bond for sale to the public must file with the Securities and Exchange Commission. It is vital to read a prospectus in order to make informed investing decisions.
By diversifying your portfolio, you’ll give yourself an opportunity to grow your money despite the ups and downs that come with investing.
By far, the most popular form of diversification is asset allocation. By having elements of different investment classes in your portfolio—including stocks, bonds, cash, real estate, gold, or other commodities—you can protect your portfolio from losing the value that it might if it only contained one failing asset category.
When stock prices fall, for example, bond prices often rise because investors move their money into what is considered a less risky investment. So a portfolio that included stocks and bonds would perform differently than one that included only stocks at the time of a stock market drop. While it's true your portfolio wouldn't rise as quickly as it would with all stocks, it also protects you from a massive loss.
Diversifying Asset Classes
It is also wise to diversify within asset classes. Investors who loaded up on tech stocks in 2000 lost their shirts when the dot-com bubble burst and technology shares rapidly fell out of favor. Similarly, financial stocks were hammered down in late 2007 and early 2008 due to the subprime mortgage crisis. Anyone exclusively invested in these assets at those times would have experienced significant losses.
And if it seems risky to put all or most of your money into a single sector, it would be even riskier to do the same on a single stock. That's what many investors did in the late 1990s, when many employees of tech companies allowed their holdings to become top-heavy in their employer’s stock. These essentially one-stock portfolios were akin to flagpole sitters in the 1920s, perched high in the air with only a long, narrow pole for support.
Consider anyone who was heavily invested in Amazon at the turn of the millennium. In December of 2000, shares of Amazon were selling for more than $100. By the following October, they had fallen to below $6. If you were banking on those stocks at that time, you were in for a rude awakening. It wasn’t until December of 2007 that it had climbed back into the $90 range.
The Bottom Line
The two basic steps to diversification are to spread your money among different asset categories, then further allocate those funds within each category. A smart approach for individual investors is to diversify using mutual funds. Because mutual funds are groups of stocks, you’ll automatically be diversified to a certain degree. A financial advisor can help you select mutual funds that fit your desired risk and diversification level.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.