What is a diversification strategy?
Managing risk with a diversified investment portfolio
Diversification is a strategy to help manage risk when investing. The concept has been understood since the first farmer dropped his eggs on the way to market, then realized it’s best not to put them all in one basket. In the same way, investors manage risk by thinking of their retirement investments as many eggs and putting them into different “baskets.”
Diversification entails investing in different asset classes such as stocks and bonds, as well as among different assets within each class. The details of your diversification strategy will depend on your time horizon and your tolerance for risk.
Explaining asset classes
- Stocks—shares in companies—will probably make up most of your portfolio. Over multi-year timelines, stocks have historically outperformed other assets. They’re a time-tested way to help protect against inflation. But stocks generally carry greater risk, especially in the short term, since markets can go up or down and individual companies can thrive or go belly up.
- Bonds are loans to governments or companies, for which you receive interest payments and, eventually, your principal in return. They’re often considered lower-risk than stocks—especially U.S. government bonds—but in return you typically won’t earn as much over time.
- Other asset classes that could be part of a diversification strategy include commodities like gold or corn, real estate and even cryptocurrency. Generally, these make up a small percentage of investor portfolios, if they’re included at all.
Diversifying within asset classes
Two baskets are better than one, but it’s not enough to invest in just one corporate stock (like the company you work for) and one government bond. Instead, you want to make sure you have a diverse mix of stocks and bonds. Here are some considerations for diversifying within asset classes:
- Sometimes economic trends favor large companies, while other times they favor smaller, more nimble companies. It’s often a good idea to cover all of your bases with a mix of so-called large-cap companies (meaning companies with a market capitalization of more than $10 billion), mid-cap companies ($2-10 billion) and small-cap companies (less than $2 billion).
- Some companies, like Coca-Cola for example, have been around for many decades and aren’t expected to grow fast. Instead, they pay shareholders annual dividends. These income stocks can increase returns when the dividends are reinvested. On the other hand, so-called growth stocks, which include most tech companies, don’t pay dividends. With these stocks, you’re betting instead on the share price growing exponentially.
- Different sectors perform differently at different times. For example, during the pandemic, airline stocks were hit hard, while online retailers thrived.
- Location also matters. Many people like to invest some of their portfolio in foreign companies, since their performance doesn’t always track that of U.S. stocks.
- When it comes to bonds, you can choose different maturity dates, which will pay different interest rates and perform differently as markets fluctuate. A diversified portfolio might contain a mix of five-year, 10-year and 30-year Treasury bonds.
- Bonds also vary in terms of credit risk, meaning the likelihood that the issuer will default. The U.S. Treasury has never defaulted on a bond, but some highly indebted companies can and do default. In return for taking on more credit risk, you may earn more interest.
Diversification made easy
How is an average investor supposed to wade through all the diversification options? An easy way is by investing in a mix of mutual funds, which do the work for you. Some funds invest in hundreds or even thousands of companies, while others hold dozens of highly rated bonds. Some funds, known as target date or asset allocation funds, are even intended to act as all-in-one investment for your retirement savings.
Note that diversification helps reduce but never eliminates risk. Sometimes all stocks, or all bonds, drop at the same time, and sometimes both stocks and bonds drop at once. Asset allocation and diversification do not ensure a profit or protect against loss. Still, diversification is a time-tested strategy that generally helps produce stronger results over time.
There is no single “best” way to diversify, but you may want to consider consulting a financial professional to help you develop a plan that aligns to your unique situation and goals.