Diversification, the practice of spreading investments across different asset classes, is one of the most fundamental principles of investing. It helps reduce overall risk, but even a well-diversified stock portfolio cannot eliminate market risk (or systematic risk), which affects all equities to some degree.
Below, we explore how diversification works and how investors can build portfolios that balance growth and stability.
Key Takeaways
- A well-diversified portfolio can mitigate the exposure to market risk.
- Diversification works by spreading your investments among a variety of asset classes: stocks, bonds, cash, Treasury bills (T-bills), real estate, precious metals, etc.
- The different assets should have a low correlation to each other, meaning that they move in exact opposition.
- Investing fully in stocks is considered riskier than a portfolio with a more diversified set of asset classes, since it can be hit incredibly hard by a market crash.
What Exactly Is Diversification?
Diversification works by spreading your investments among a variety of asset classes (such as stocks, bonds, cash, Treasury bills or T-bills, real estate, etc.) that have a low correlation to each other. Low correlation reduces volatility. The assets rise and fall in price at different times, at different rates, and based on a variety of factors. A portfolio holding diversified assets helps to create more consistency and improve overall performance.
How Does Correlation Work?
Correlation measures how closely two investments move in relation to each other. It’s expressed as a number between –1 and +1, indicating the strength and direction of their relationship.
- A correlation of +1 means two assets move perfectly together in lockstep both up and down.
- A correlation of 0 means there’s no consistent relationship between how the assets move.
- A correlation of –1 means the assets move in exact opposition. When one asset rises, the other falls.
Understanding correlation helps investors combine assets that don’t move together, which smooths returns and reduces portfolio volatility.
Diversified Stock Portfolio vs. Diversified Portfolio of Assets
When we talk about the importance of diversification in a stock portfolio, we’re referring to an investor’s attempt to reduce exposure to unsystematic risk (i.e., company-specific risk) by investing in various companies across different sectors, industries, or even countries. A diversified stock portfolio contains a broad variety of stocks, but it is still focused on that single asset class.
Investors who prefer to invest primarily in the stock market may find that exchange-traded funds (ETFs) and mutual funds provide an easy method for diversification. In both of these assets, funds pool money to purchase shares across a wide range of companies, geographies, sectors, or indexes. The automatic diversification in each share purchased eliminates company-specific risk. For example, a total market or S&P 500 ETF provides exposure to hundreds of stocks in one investment. Investors who want to expand further can use sector-specific or international funds to gain exposure to different industries or regions without having to select individual stocks.
When we discuss diversification among asset classes, the same concept applies but over a broader range. By diversifying holdings across different asset classes, the investor reduces exposure to the systemic risk of any one asset class. Thus, if a market crash sends all of the prices of the stocks in the portfolio tumbling, other uncorrelated assets may not lose value at the same time, providing additional stability.
Like holding a single company in your stock portfolio, having your entire net worth in a portfolio of any one asset (even if that portfolio is diversified) constitutes putting all of your eggs in one basket. You are still very much exposed to market risk. By investing in a broad number of assets, you reduce exposure to market risk or the systemic risk of any one asset class.
Although diversification is no guarantee against losses, investing professionals see this as a prudent long-range strategy.
How to Diversify Your Portfolio
Fixed-Interest Investments
Bonds are a popular way to diversify due to their low correlation with other major asset classes, particularly equities. Other fixed-interest investments such as Treasury bills (T-bills), bankers’ acceptances, and certificates of deposit (CD) are also popular. Investors typically view these asset classes as less prone to risk compared with stocks. Conversely, they may also provide lower returns.
Real Estate
Another option is real estate, which has a relatively low correlation with stocks. Adding some real estate to your portfolio is a practical way to diversify, largely because many people (through homeownership) are invested in the real estate market.
It’s amazing how often investors overlook the potential of real estate. Investing in real estate doesn’t require purchasing a house or building. Real estate investment trusts (REITs) provide an easy and less expensive alternative to buying property directly. REITs trade like stocks on the major exchanges. They invest directly in property and mortgages and typically offer high yields. Because real estate has a relatively low correlation with stocks, investing in REITs is a good way to diversify away from equities.
Safe Haven Assets
So-called safe haven assets are those specifically utilized to provide stability to a portfolio during times of market turmoil. While some of the assets listed above can be safe havens, the iconic safe haven asset is gold. Gold (and other precious metals) are stores of value that are not subject to issues related to interest rates. Although some investors may debate the value of gold as a safe haven, it has tended historically to maintain its value over time. This means that it can be a hedge against inflation and adverse market conditions.
Currencies
Currencies can be an important part of a diversification strategy. In some ways, cash is the ultimate safe haven asset. However, it is generally not advisable to hold cash over a long period, as it provides little by way of yield or return and is negatively impacted by inflation.
Explain Like I’m 5
Diversification means instead of putting all of your money in one company or one type of asset that you spread your money across a few different areas like stocks, bonds, real estate so that one bad day in the market does not derail your entire plan.
When you don’t put all your eggs in one basket, or money in one stock or asset, you create a portfolio where when one investment falls, another may rise. The goal isn’t to eliminate risk altogether (that’s impossible), but to make the ups and downs of investing more manageable and keep your long-term plan on track.
How Many Stocks Does It Take to Diversify a Portfolio?
There is no hard-and-fixed number of stocks to diversify a portfolio. Generally, a portfolio with a greater number of stocks is more diverse. However, some things to keep in mind that may impact diversification include the fact that the qualities of the stocks (including their sectors, size and strength of the company, etc.) have an impact. Additionally, stock portfolios are generally still subject to market risk, so diversifying into other asset classes may be preferable to increasing the size of a stock portfolio.
Is It Possible to Over-diversify a Portfolio?
It is. A portfolio becomes over-diversified if an investment added to the portfolio lowers the expected return more than it lowers the risk profile. In this case, the portfolio is not best able to capture returns given its risk considerations.
Should You Be 100% Invested in Stocks?
Investing fully in stocks is generally considered riskier than a portfolio with a more diversified set of asset classes. The reason for this is that an all-stock portfolio can be hit incredibly hard by a market crash. By adding other asset classes, including bonds, Treasury bills (T-bills), real estate, or precious metals to a portfolio, you can limit this risk.
The Bottom Line
Diversification is a key building block to anyone’s financial plan, including understanding what diversification does and how it helps an individual’s overall financial position. It is crucial that investors know the difference between systematic and unsystematic risk, as well as understand that by diversifying among asset classes, they can mitigate exposure to systematic risk.