What does diversification mean for investors?

One of the golden rules of investing is to spread your money across a range of different asset classes. This approach means that if one or more of your investments rise you will benefit but, if they fall, there should be a degree of protection because, hopefully, some of your other holdings in different asset classes will be going up in value. However, diversifying doesn’t mean shortening the period of time you invest over. You should be thinking long term (at least five years) for all your investment allocations.

What does diversification mean?

Diversification means making sure you’re not relying on one type of investment too heavily. This helps to protect your investments and reduce the overall risk of losing money.

There are four main asset classes - cash, fixed-interest securities, property and equities – and having exposure to them all will help reduce the overall level of risk of your investment portfolio.  If one part of your portfolio isn’t doing well, the other investments you’ve made elsewhere should compensate for those losses.

It can work on so many levels

Investing in just one company is extremely risky, because if it doesn’t perform you’ll lose money. Investing in lots of companies means that even if one does badly, others may do well, limiting your losses.

You can further diversify your portfolio by spreading your investments over several geographical areas. If you invest in companies from different countries then even if, say, manufacturing is performing poorly in the UK, it might be flourishing in the Far East. You can take this up another level by investing in different sectors. And so if manufacturing underperforms in several countries at once, other sectors you’re investing in could be outperforming their markets.

Make sure you are comfortable with the risks involved when investing in different regions. For example, emerging markets such as Brazil, Russia, India and China are likely to be more volatile than developed markets such as the UK and US.

Find out more about asset allocation

Funds – diversification made easy

You can gain access to several different geographical areas through managed funds such as unit trusts, Open-Ended Investment Companies (OEICs) and investment trusts.

These are collective investments, whereby your money is invested with other investors in a range of different holdings. Some funds focus on a specific area, type of investment or sector, while others are more general and invest across several regions and sectors.

Fund managers publish information about the underlying asset allocation of a fund, so make sure you look at this before investing.

Find out more about an introduction to funds

Thinking about risk and return

Diversification isn’t a magic bullet and it won’t stop you experiencing losses. But it can help you spread your overall risk. Do remember, though, that you can’t get rid of risk completely. Any investment can go up or down in value and you could make or lose money. The key is to find a spread of investments and a level of risk and return that you’re comfortable with.

Assets like bonds and gilts can help offset riskier investments like shares, but the downside is they don't offer the same potential for higher returns. Cash investments are also less risky than shares, but if the cost of living rises ahead of any interest you're getting, your money could actually fall in 'real' value over time.

The investments you pick for your portfolio will depend on how long you plan to invest (which should be for at least a five year term), how much risk you’re happy to take and your financial objectives. If you’re not sure which investments to choose, you may want to get independent financial advice.

No matter what approach you take to diversification, you have to accept that you can still get back less than you invest.

Find out more about understanding risk and return

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.

Diversification is the process of spreading out your money in different investments, so that you’re not too exposed to any one investment. Diversification can increase your overall return without requiring you to sacrifice something in exchange, offering what economists call a “free lunch.” In other words, diversification can actually reduce risk without costing your returns.

Here’s how diversification works, why it’s so important and how to diversify your portfolio.

What is diversification?

Diversification means owning a variety of assets that perform differently over time, but not too much of any one investment or type. In terms of stock investing, a diversified portfolio would contain 20-30 (or more) different stocks across many industries. But a diversified portfolio could also contain other assets – bonds, funds, real estate, CDs and even savings accounts.

Each type of asset performs differently as an economy grows and shrinks, and each offers varying potential for gain and loss:

• Stocks offer the potential for the highest return over time, but can fluctuate wildly over shorter periods.
• Bonds can offer steadier returns with a fixed payout, but can vary as interest rates rise and fall.
• Funds tend to be diversified because they usually hold many investments, but a specific fund may hold only one kind, for example, consumer goods companies. So, a fund could be broadly diversified or narrowly, depending on how it’s managed.
• Real estate can appreciate slowly over time and offer the potential for income, too. But physical real estate can be expensive to maintain, and commissions are high.
• CDs and savings accounts will not fluctuate in value but will grow steadily based on the interest rate or other contractual terms.

As some of these assets are rising rapidly, others will remain steady or fall. Over time, the frontrunners may turn into laggards, or vice versa. In other words, these assets are not highly correlated with one another, and that’s key to the appeal of diversification.

And it’s easier and cheaper than ever to ensure that your portfolio has a broad array of investments, with zero commissions at major online brokerages.

How diversification benefits you

Diversification has several benefits for you as an investor, but one of the largest is that it can actually improve your potential returns and stabilize your results. By owning multiple assets that perform differently, you reduce the overall risk of your portfolio, so that no single investment can hurt you too much. It’s this “free lunch” that makes diversification a truly attractive option for investors.

Because assets perform differently in different economic times, diversification smoothens your returns. While stocks are zigging, bonds may be zagging, and CDs just keep steadily growing.

In effect, by owning various amounts of each asset, you end up with a weighted average of the returns of those assets. Although you won’t achieve the startlingly high returns from owning just one rocket-ship stock, you won’t suffer its ups-and-downs either.

While diversification can reduce risk, it can’t eliminate all risk. Diversification reduces asset-specific risk – that is, the risk of owning too much of one stock (such as Amazon) or stocks in general, relative to other investments. However, it doesn’t eliminate market risk, which is the risk of owning that type of asset at all.

For example, diversification can limit how much your portfolio falls if some stocks decline, but it can’t protect you if investors decide they don’t like stocks and punish the whole asset class.

For assets sensitive to interest rates, such as bonds, diversification helps protect you from a problem at a specific company, but it won’t protect you from the threat of rising rates generally.

Even cash, or investments such as CDs or a high-yield savings account, are threatened by inflation, although deposits are typically guaranteed from principal loss up to $250,000 per account type per bank.

So diversification works well for asset-specific risk, but is powerless against market-specific risk.

How to develop a diversification strategy

With the advent of low-cost mutual funds and ETFs, it’s actually simple to create a portfolio that’s well-diversified. Not only are these funds cheap, but major brokerages now allow you to trade many of them at no cost, too, so it’s tremendously easy to get in the game.

A basic diversified portfolio could be as simple as holding a broadly diversified index fund such as one based on the Standard & Poor’s 500 index, which owns stakes in hundreds of companies. But you’ll probably want some exposure to bonds as well to help stabilize the portfolio, and guaranteed returns in the form of CDs help, too. Finally, cash in a savings account can also give you stability as well as a source of emergency funds if you need it.

If you want to expand beyond this basic approach, you can diversify your stock and bond holdings. For example, you might add a fund that owns companies in emerging markets or international companies more generally, because an S&P 500 fund doesn’t own those. Or you may opt for a fund comprised of small public companies, since that too is outside the S&P 500.

For bonds, you might choose funds that have short-term bonds and medium-term bonds, to give you exposure to both and give you a higher return in the longer-dated bonds. For CDs, you can create a CD ladder that gives you exposure to interest rates across a period of time.

Some financial advisors even suggest that clients consider adding commodities such as gold or silver to their portfolios to further diversify beyond traditional assets such as stocks and bonds.

Finally, however you construct your portfolio, you’re looking for assets that respond differently in different economic climates. It doesn’t create diversification if you have different funds that own all the same large stocks, because they’ll perform mostly the same over time.

And if all this sounds like too much work, a fund or even a robo-advisor can do it for you. A target-date fund will move your assets from higher-return assets (stocks) to lower-risk (bonds) over time, as you approach some target year in the future, typically your retirement date.

Similarly, a robo-advisor can structure a diversified portfolio to meet a specific goal or target date. In either case, you’re likely to pay more than if you did it yourself, however.

Bottom line

Diversification offers an easy way to smoothen your returns while potentially increasing them as well. And you can have a variety of models for how diversified you want your portfolio to be, from a basic all-stock portfolio to one that holds assets across the spectrum of risk and reward.

Why is diversification so important to investors?

How does diversification affect investment?

What is an example of a diversified investment?

What happens when an investor over diversified?