What Is Diversification?
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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