Portfolio diversification: What investors need to know
“Don’t put all your eggs in one basket” is a well-worn piece of advice we’ve all heard. It’s a cliché, to be sure, but one worth repeating because it’s the best way to sum up one of the core concepts of investing: portfolio diversification.
In its simplest form, diversification means spreading your investment dollars across different asset classes, such as stocks, bonds, and other investments, like foreign currencies, commodities, and even cryptocurrencies. Diversification also means owning many types of stocks and bonds in different sectors and industries, and from many regions around the globe.
Key Points
- A diversified portfolio contains a mix of many different stocks, bonds, and alternative investments.
- Mutual funds and ETFs are easy ways to seek diversification.
- Remember to monitor your portfolio for changes in concentration and risk levels.
Diversification allows you to take advantage of as many growth opportunities as possible. At the same time, it helps you mitigate risk, particularly the risk of losing too much money on any single investment.
Diversification 101: An example
Let’s say your employer, as part of your compensation, awards you $10,000 in company stock. The company is doing well, and the price of its stock is rising. You may want to hold on to the stock as it rises.
If that stock is the only one you own, however, you have what’s called a “concentrated” portfolio. As long as the stock keeps going up, that may seem like a good thing. But no stock goes up forever.
You may want to take that $10,000—or a portion of it—and build a diversified portfolio. You could sell some shares of the company stock and invest in a wide range of stocks and bonds, either directly through a brokerage account or by purchasing mutual funds or exchange-traded funds (ETFs), which spread pools of investments across a wide range of securities. In other words, they diversify their holdings.
By having a diversified portfolio, you’ll participate in the earnings and growth of other companies and industries—not just those of your company. And if the stock of your company should drop, diversification can soften the blow.
Adjusting your level of diversification
Even a diversified portfolio needs some love and attention—and perhaps the occasional tweak. Investment pros call it a portfolio review and rebalance. There are two common reasons for the review/rebalance exercise:
1. Concentration creep. Suppose a few years ago, your $20,000 portfolio consisted of two holdings: $10,000 (or 50%) in an ETF that tracks the S&P 500 (SPX) and $10,000 (the other 50%) in a high-flying growth stock, say Netflix (NFLX). By late 2021, the $10,000 in the index would have appreciated about 80%, but Netflix would have soared 260% (see chart).
At that point, your portfolio concentration would have deviated greatly from 50/50, with Netflix comprising two-thirds of your portfolio:
| Netflix | $10,000 + 260% = $36,000 |
| S&P 500 ETF | $10,000 + 80% = $18,000 |
| Portfolio value | $36,000 + $18,000 = $54,000 |
| Netflix concentration | 36,000/54,000 = 66.67% |
| S&P 500 ETF concentration | 18,000/54,000 = 33.33% |
In this example, a periodic review and rebalance could have prompted you to mitigate your downside risk before tech platforms such as Netflix fell back to earth in 2021 and 2022.
2. Your risk profile changes over time. When you begin investing for a faraway goal such as retirement or a child’s education, you can afford to take some additional risk in search of a higher return. A long-term portfolio can generally ride out the ebbs and flows of the market. But as that goal gets closer (i.e., when you’re about to retire or start writing those tuition checks), you’re less likely to want the added risk of a big sell-off right when you’re planning to liquidate your portfolio for cash. In both cases, diversification is a moving target.
How to diversify today
There are numerous ways to diversify. Mutual funds and ETFs offer easy ways to own large segments of the overall stock and/or bond market with a few holdings. Balanced funds typically hold highly diversified baskets of stocks and bonds.
Lifecycle or target-date funds are another strategy that many retirement-minded investors choose. They offer portfolios of stocks and bonds that adjust over time—from a growth orientation to a less risky composition—as the investor nears the date in the fund’s name (for example, a 2060 fund would be invested mostly in cash by the year 2060).
You may also want to consider automated investment guidance, or a “robo-advisor,” to help you diversify. These highly automated platforms ask you a series of questions about your goals, risk tolerance, and other factors, then deliver a personalized—and diversified—investing plan. The robo-advisor will then adjust your portfolio over time. Most of the top retail brokers and fund companies offer this sort of service, typically for an annual fee.
The bottom line
Diversification is a core principle for investors in any market, and for good reason. No one can predict what any investment will deliver over time. But by casting a wide net, investors are more likely to find growth opportunities and avoid steep losses—or at least mitigate the damage from market sell-offs—over the long haul.