What Is Diversification? A Guide to Protecting Your Portfolio | Stash Learn

What Is Diversification? A Guide to Protecting Your Portfolio

By: Team Stash
Published: Apr 18, 2023
• Updated: Sep 19, 2024

Diversification is an investment strategy that spreads the holdings in your investment portfolio across different asset classes to reduce overall risk. In other words, diversification follows the old adage “don’t put all your eggs in one basket.” If you drop the basket, you risk losing all of your eggs at once. Putting all of your money into just one stock, or even a narrow selection of stocks, bonds, or funds, can be risky for the same reason. Market fluctuations are inevitable, but a diversified portfolio can provide a cushion: if one of your specific investments loses value, others may hold steady or even grow. That can mean more protection against volatility in the market.

The importance of diversification

Many new investors focus only on how to buy stocks, but that narrow view can miss an important way to reduce risk. Diversification in investing means spreading your money across asset classes rather than putting it all into just one type of investment. That helps protect your portfolio because various asset classes, like stocks, bonds, and funds, have different levels of risk and volatility, and they can even behave differently when market conditions change.

For example, say you decide to invest $300, and you put it all toward stock in Company X. If the share price then drops by 60%, your portfolio would be worth $120. That’s a pretty painful loss.

If you were to spread your $300 investment across three different types of assets rather than one specific investment, you could cushion that blow. Consider this example of diversification: suppose you spread your $300 across three asset classes: $100 in Company X’s stock, $100 in a bond, and $100 in an exchange-traded fund (ETF).

Imagine the following happens next:

Company X’s stock drops by 60%. Your investment is now worth $40
The value of the bond stays the same. Your investment is still worth $100
The value of the ETF shares increase by 30%. Your investment is now worth $130

In this scenario, your total portfolio would now be worth $270. You’d have lost some value in your stocks, but gained a bit through your ETF. That stings a lot less. This simple example displays how asset allocation, or selecting a variety of asset classes for your portfolio, can reduce risk to your portfolio when one type of investment loses value.

Benefits of diversification:

Reduce investment risk: Spreading your investments around can smooth out the big dips and spikes in the market.
Increased returns: Some assets will perform well one year, while others do poorly. The next year their positions may reverse. Over the long term, these fluctuations tend to balance out to maximize your returns with minimized risk.
Exposure to different markets: Investing across industries, sectors, geographic regions, and asset classes allows you to leverage the ups and downs of different markets. When one is underperforming, another can make up the difference.
Support for both short- and long-term goals: Different time horizons require different types of investments. Portfolio diversification allows you to both plan for retirement and realize shorter-term goals like putting a down payment on a home or buying a new car.

Know that diversification doesn’t cut out all risk

There is no such thing as risk-free investing. So while the purpose of diversification is to reduce your overall risk as an investor, your portfolio will still be subject to both overall market and asset-specific risks, also known as systematic and unsystematic risk.

Systematic risk: This type of risk is tied to the broader market, and it’s inherent to any type of investing. Systematic risks, also known as volatility risks, include inflation, recessions, interest rate fluctuations, natural disasters, and geopolitical conflict.
Unsystematic risk: This type of risk, also known as company-specific risk, is tied to investment in a specific industry or company.

Types of diversification

The benefits of diversification may be clear, but exactly how do you diversify your investments? Simply buying lots of different securities doesn’t necessarily create a well-balanced portfolio. You’ll want to understand three types of diversification:

Diversifying by asset classes

There are a number of different asset classes to choose from. Common asset types include stocks, bonds, various kinds of funds, and cash.

Stocks (equities): Stocks are securities that represent a unit of ownership in a company. Higher risk.
Bonds (fixed income): A bond is a debt security, similar to an IOU. Lower risk.
ETFs: An ETF is a diversified basket of securities like stocks, bonds, and commodities. Generally lower-risk.
Mutual funds: Like an ETF, a mutual fund is a collection of investments. Generally lower-risk.
Index funds: This type of investment is built to mirror the performance of a specific market index. Lower risk.
Cash (or cash equivalents): This refers to cash or any assets that can be readily converted to cash. High liquidity, lower risk.

Diversifying by industry and sector

Spreading your money across industries and sectors can reduce risk, as performance can vary significantly among them. The U.S. stock market contains 11 different sectors:

Information technology
Healthcare
Financials
Consumer discretionary
Communication services
Industrials
Consumer staples
Energy
Utilities
Real estate
Materials

Diversifying by location

When building a diversified portfolio, you don’t have to limit yourself to U.S. securities. It’s possible to invest in Europe, Asia, South America, and beyond.

Things to consider when diversifying your portfolio

Your investment choices are personal, reflecting your goals and values. That means your approach to asset allocation will be personal as well. Keep these five ideas in mind as you explore your options:

1. Consider your investment goals

Are you aiming for long-term gains to fund a retirement nest egg or a young child’s college education, or do you have shorter-term goals? Your time horizon can help you determine if your asset allocation should be more heavily weighted toward investments that tend to build wealth over time or if you’re willing to take a bit more risk for potential earlier rewards.

2. Know your risk tolerance

Everyone’s comfort level is different when it comes to taking risks with money. Factors that can influence your risk tolerance include your amount of discretionary income, how soon you’re counting on your investments to grow, and whether uncertainty tends to cause you anxiety in general.

3. Invest in different asset classes and more

A mix of stocks, bonds, funds, and other assets leads to a more diversified portfolio.

4. Avoid over-diversification

If a diversified portfolio can help reduce risk, over-diversification may seem counterintuitive. But there can be too much of a good thing.

5. Review and rebalance your portfolio

The market is always changing, so a well-diversified portfolio today may drift away from your ideal asset allocation later. Periodically review your portfolio’s asset allocation and, if it no longer reflects your goals, decide which assets to buy, sell, or hold to bring it back on target.

Diversification: protecting your nest eggs with multiple baskets

As you move forward with your financial goals, diversification can help you strike the right balance between risk and possible rewards. Building a diversified portfolio, along with investing regularly and investing for the long term, is a core component of the Stash Way, our investment philosophy focused on building wealth over time.

Knowing the answer to “What is diversification?” is a first step; the next is applying what you’ve learned to your investment decisions. Whether you’re brand new to investing or are looking to improve your investment strategy, diversification can help you protect your investments for long-term success.