What Is Diversification?
Written by Andrea Coombes
Edited by Carolyn Kimball
Fact-checked by Dayana Yochim
You’ve probably heard that diversification is important when you invest. But what is diversification, exactly? And why should we care? Diversification is essentially investor-speak for “don’t put all of your eggs in one basket.”
Quick take: Diversification is about spreading our money around to different types of investments. Building a diversified portfolio helps protect our money in times of volatility.
Tell me more! A diversified portfolio can be built many different ways. You can diversify:
- …across companies, so instead of putting all of your money into, say, Apple shares, you own Apple, Alphabet and Meta.
- …across industries, so instead of all-tech, you own tech stocks, consumer staples stocks, travel stocks, and so on.
- …geographically, by owning U.S. companies plus companies in emerging and/or developed markets elsewhere.
- …by company size, owning shares of small-cap, mid-cap and large-cap companies (“cap” refers to market capitalization, aka the company’s total number of shares multiplied by its share price).
- …across asset classes, so not only do you own stocks, but also bonds, maybe even real estate, commodities and crypto.
- …across time, e.g. buying shorter-term vs. longer-term bonds.
- …across risk, e.g. lower-risk government debt vs. higher-risk corporate bonds.
But building a diversified portfolio can be way easier than researching and buying all of those individual investments yourself. Here are a couple of super easy ways to build a diversified portfolio:
- Buy a target-date fund, that is, a fully diversified portfolio in one fell swoop.
- Buy a handful of mutual funds, such as a total stock market fund, a total bond market fund, maybe some type of international fund and/or real-estate sector fund. You can use traditional mutual funds or exchange-traded funds (ETFs). A mutual fund or ETF gives you exposure to potentially thousands of companies with one single share, making diversification easy-peasy. Read more about mutual funds or ETFs.
One more thing: Do you know the difference between diversification and asset allocation? Diversification is spreading your money around to different types of investments to reduce risk. Asset allocation is deciding how much of your money to invest in each type of investment.
Bottom line: Diversification is about investing in a way that reduces your exposure to any one company, asset or sector’s risk. That can help protect your investment portfolio in times of volatility. You can build a highly diversified portfolio with two or three index mutual funds or ETFs.
Real talk about diversification...
The sad truth is that diversification is not a perfect science. Diversification can help mitigate specific risks related to companies, industries and asset classes. It usually doesn’t help with systemic risk, such as a major economic meltdown during which everything might drop in value.
Even with a diversified portfolio, you can and likely will see the value of your investments drop at times. Notice that I didn’t say, “You will lose money.” Because you will only lose money if you end up needing to sell your investments when they’ve dropped in value. That’s why investing is, for most of us, better played as a long-term game — you want time on your side so you can hold onto your highly diversified portfolio until it gains value again.
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About the Editorial Team
Andrea Coombes has 20+ years of experience helping people reach their financial goals. Her personal finance articles have appeared in the Wall Street Journal, USA Today, MarketWatch, Forbes, and other publications, and she's shared her expertise on CBS, NPR, "Marketplace," and more. She's been a financial coach and certified consumer credit counselor, and is working on becoming a Certified Financial Planner. She knows that owning pets isn't necessarily the best financial decision; her dog and two cats would argue this point.
Carolyn Kimball is Managing Editor for Reink Media Group and the lead editor for content on investor.com. Carolyn has more than 20 years of writing and editing experience at major media outlets including NerdWallet, the Los Angeles Times and the San Jose Mercury News. She specializes in coverage of personal financial products and services, wielding her editing skills to clarify complex (some might say befuddling) topics to help consumers make informed decisions about their money.
Dayana Yochim has been writing (articles, books, podcasts, stirring speeches) about personal finance and investing for more than two decades, focusing on bringing clarity and the occasional comedic aside to what is often a murky, humorless topic. She’s written for NerdWallet, The Motley Fool, HerMoney.com, Woman’s Day, Forbes, Newsweek and others, and been a guest expert on "Today," "Good Morning America," CNN, NPR and wherever they’ll hand her a mic.
