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Diversification: Definition, How It Works
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What Is Diversification? How It Works, Benefits
Diversification is the act of spreading investment dollars across a range of assets to reduce investment risk.
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Elizabeth Ayoola is a Lead Multimedia Producer and Co-Host of the "Smart Money" podcast. Before delving into the podcast world, Elizabeth acquired over ten years of experience as a writer, and seven were spent covering personal finance topics. Her journey to finance writing started with a goal to learn as much as she could about how to attain financial freedom and share information with others about how to do it, too. This led her to Debt.com, where she covered topics relating to mortgages, debt and credit. Her articles have appeared on platforms like Washington Post, The Associated Press, The Washington Post, Yahoo, Essence, The Knot, PopSugar and Parents.com. Elizabeth has also done extensive spokesperson work and appeared on multiple renowned national networks like Good Morning America, ABC, NBC, and Fox to discuss money. Published in Writer + more + moreWhat is diversification?
What is diversification?Diversification is an investing strategy in which an investor spreads investments across different asset classes to reduce the risk of loss. Because different asset classes react differently to market changes, diversification helps reduce the risk that a single market event or an investment’s poor performance will decimate an investor’s portfolio.
Diversification is an investing strategy in which an investor spreads investments across different asset classes to reduce the risk of loss. Because different asset classes react differently to market changes, diversification helps reduce the risk that a single market event or an investment’s poor performance will decimate an investor’s portfolio.Brokerage firms
Brokerage firms
Brokerage firmson Charles Schwab's website
on E*TRADE's website
on Vanguard's website
on Fidelity's website
How diversification works
How diversification worksDiversification may look different for each investor. Your risk tolerance and how long you plan to invest are just two factors that affect your strategy. But in general, to achieve diversification, investors blend dissimilar assets together (like stocks and bonds) so that their portfolio does not have too much exposure to one individual asset class or market sector.
Diversification may look different for each investor. Your risk tolerance and how long you plan to invest are just two factors that affect your strategy. But in general, to achieve diversification, investors blend dissimilar assets together (like stocks and bonds) so that their portfolio does not have too much exposure to one individual asset class or market sector.The four main general asset classes in an investment portfolio are stocks, bonds, cash and alternative investments.
The four main general asset classes in an investment portfolio are stocks, bonds, cash and alternative investments.Stocks (or equities). These instruments allow investors to own a piece of a company. Stocks can offer high long-term gains but can be volatile.
Stocks (or equities). These instruments allow investors to own a piece of a company. Stocks can offer high long-term gains but can be volatile.Bonds (or fixed income) pay interest to investors who lend money to a company or government. Bonds are income generators with typically relatively modest returns. Generally, bond prices have an inverse relationship with stock prices.
Bonds (or fixed income) pay interest to investors who lend money to a company or government. Bonds are income generators with typically relatively modest returns. Generally, bond prices have an inverse relationship with stock prices.Cash (or cash equivalents) is the money in your savings account, pocket or hidden under your pillow. In terms of risk and return, cash is low on both counts. Cash can buffer volatility or unexpected expenses and acts as “dry powder” to invest during opportune times.
Cash (or cash equivalents) is the money in your savings account, pocket or hidden under your pillow. In terms of risk and return, cash is low on both counts. Cash can buffer volatility or unexpected expenses and acts as “dry powder” to invest during opportune times.Alternative investments (“alts”) include things such as real estate, private equity, crypto, art or precious metals. Pensions, annuities and insurance can also factor in. These asset classes usually have a lower correlation to the stock market and can, as such, be effective in aiding diversification. However, they can be relatively risky and complex.
Alternative investments (“alts”) include things such as real estate, private equity, crypto, art or precious metals. Pensions, annuities and insurance can also factor in. These asset classes usually have a lower correlation to the stock market and can, as such, be effective in aiding diversification. However, they can be relatively risky and complex.For example, say you invest all of your money only in Apple stock (AAPL). This would mean that your asset allocation is 100% equity (or stock) and all in the technology sector. This is risky because if Apple’s stock price drops, your whole portfolio suffers. You might diversify within the technology sector by investing in other tech stocks, but if the whole technology sector is negatively affected, your portfolio might still take a big hit.
For example, say you invest all of your money only in Apple stock (AAPL). This would mean that your asset allocation is 100% equity (or stock) and all in the technology sector. This is risky because if Apple’s stock price drops, your whole portfolio suffers. You might diversify within the technology sector by investing in other tech stocks, but if the whole technology sector is negatively affected, your portfolio might still take a big hit.To diversify to portfolio, you may want to buy stocks in other sectors. You may also want to buy bonds or other fixed-income securities to protect against a stock market correction (bond prices tend to rise when stock prices decline).
To diversify to portfolio, you may want to buy stocks in other sectors. You may also want to buy bonds or other fixed-income securities to protect against a stock market correction (bond prices tend to rise when stock prices decline).» MORE: See our picks for the best financial advisors
» MORE: » MORE: See our picks for the best financial advisorsPros and cons of diversification
Pros and cons of diversification ProsReduces risk.
Can create steadier portfolio performance.
ConsDilutes effects of outperformers.
Doesn't eliminate all risk.
Benefits of diversification
Benefits of diversificationDiversification is a simple way to reduce risk. By not putting all your eggs in one basket, you protect your portfolio from market volatility.
Diversification is a simple way to reduce risk. By not putting all your eggs in one basket, you protect your portfolio from market volatility.Also, the net effect of diversification can be relatively slow and steady performance, as well as smoother returns that don't move up or down too quickly. That reduced volatility puts many investors at ease.
Also, the net effect of diversification can be relatively slow and steady performance, as well as smoother returns that don't move up or down too quickly. That reduced volatility puts many investors at ease.Disadvantages of diversification
Disadvantages of diversificationThe trade-off of diversification is that you never fully capture the startling gains of a shooting star. An investment that really takes off will be tempered by other investments in your portfolio that are not performing as well.
The trade-off of diversification is that you never fully capture the startling gains of a shooting star. An investment that really takes off will be tempered by other investments in your portfolio that are not performing as well.Also, although diversification is an easy way to reduce risk in your portfolio, it can’t eliminate risk altogether. Investments are subject to two broad types of risk:
Also, although diversification is an easy way to reduce risk in your portfolio, it can’t eliminate risk altogether. Investments are subject to two broad types of risk:Market risk (systematic risk): These risks come with owning any asset, even cash. The entire market may become less valuable for all assets for many reasons, such as a pandemic or war.
Market risk (systematic risk): Market risk (systematic risk): These risks come with owning any asset, even cash. The entire market may become less valuable for all assets for many reasons, such as a pandemic or war.Asset-specific risks (unsystematic risk): These risks come from the investments or companies themselves. Such risks include the success of a company’s products, the performance of management and the stock price.
Asset-specific risks (unsystematic risk): Asset-specific risks (unsystematic risk): These risks come from the investments or companies themselves. Such risks include the success of a company’s products, the performance of management and the stock price.You can reduce asset-specific risk by diversifying your investments. However, there’s just no way to eliminate market risk through diversification. It’s a part of investing.
You can reduce asset-specific risk by diversifying your investments. However, there’s just no way to eliminate market risk through diversification. It’s a part of investing.» MORE: How capital gains tax works and how to save
» MORE: MORE: How capital gains tax works and how to saveHow to diversify a portfolio
How to diversify a portfolioThere are several methods that investors can use to diversify a portfolio.
There are several methods that investors can use to diversify a portfolio.By industry or sector
By industry or sectorThe economic cycle affects every business differently. As a result, investing in companies in all kinds of industries is one way to diversify.
The economic cycle affects every business differently. As a result, investing in companies in all kinds of industries is one way to diversify.Some sectors are cyclical, meaning the company’s performance moves in sync with the economic cycle. Examples include consumer discretionary (clothing, electronics, cars, etc.), financial services, basic materials and real estate, where demand grows as the economy gets stronger. Some sectors are defensive, meaning they are less affected by the economic cycle. Examples include consumer staples (groceries, tobacco, etc.), utilities, and health care — necessities that tend to be consumed at all times.
Some sectors are cyclical, meaning the company’s performance moves in sync with the economic cycle. Examples include consumer discretionary (clothing, electronics, cars, etc.), financial services, basic materials and real estate, where demand grows as the economy gets stronger. Some sectors are defensive, meaning they are less affected by the economic cycle. Examples include consumer staples (groceries, tobacco, etc.), utilities, and health care — necessities that tend to be consumed at all times.By size or market capitalization
By size or market capitalizationMarket cap is the total value of a company's tradable stock (number of outstanding shares x price per share). Larger companies tend to be more stable and can weather economic downturns more easily, but they also tend to have less growth potential than their smaller counterparts.
Market cap is the total value of a company's tradable stock (number of outstanding shares x price per share). Larger companies tend to be more stable and can weather economic downturns more easily, but they also tend to have less growth potential than their smaller counterparts.By style (growth vs. value)
By style (growth vs. value)Growth stocks are often relatively expensive but may have high future growth potential. Value stocks are companies whose stocks are “on sale” or seem underpriced or undervalued.
Growth stocks are often relatively expensive but may have high future growth potential. Value stocks are companies whose stocks are “on sale” or seem underpriced or undervalued.By credit quality
By credit qualityBonds offer different levels of creditworthiness or safety. For instance, Treasurys are relatively low-risk because it’s unlikely the U.S government will go bankrupt.
Bonds offer different levels of creditworthiness or safety. For instance, Treasurys are relatively low-risk because it’s unlikely the U.S government will go bankrupt.By maturity
By maturityCompared to short-term bonds, longer-term bonds may earn higher returns because they are subject to more interest rate risk.
Compared to short-term bonds, longer-term bonds may earn higher returns because they are subject to more interest rate risk.By type of issuer
By type of issuerIntegrating bonds from various issuers can help mitigate the risk of a single issuer type becoming more likely to default on debt repayments. Bond issuers include the U.S. government (such as Treasurys), municipalities, corporations and more.
Integrating bonds from various issuers can help mitigate the risk of a single issuer type becoming more likely to default on debt repayments. Bond issuers include the U.S. government (such as Treasurys), municipalities, corporations and more.By geography
By geographyDifferent countries have different economic cycles, so for some investors it makes sense to have exposure to both domestic and international markets. International or foreign markets are further classified as developed and emerging. Developed markets (e.g., European nations, Australia, Japan, Singapore, etc.) tend to be less volatile (but may have lower growth potential), whereas emerging markets (e.g., Brazil, Russia, India, China, etc.) tend to be more volatile (but may have higher growth potential).
Different countries have different economic cycles, so for some investors it makes sense to have exposure to both domestic and international markets. International or foreign markets are further classified as developed and emerging. Developed markets (e.g., European nations, Australia, Japan, Singapore, etc.) tend to be less volatile (but may have lower growth potential), whereas emerging markets (e.g., Brazil, Russia, India, China, etc.) tend to be more volatile (but may have higher growth potential).By active vs. passive method
By active vs. passive methodYou can purchase many securities through mutual funds, index funds or exchange-traded funds (ETFs). In active funds, a portfolio manager picks which stocks to include in the fund. In passive funds, the goal is to buy securities that mimic an underlying index, such as the S&P 500. Passive funds can often outperform active funds during market upswings, but active funds can offer better downside protection during market downturns.
You can purchase many securities through mutual funds, index funds or exchange-traded funds (ETFs). In active funds, a portfolio manager picks which stocks to include in the fund. In passive funds, the goal is to buy securities that mimic an underlying index, such as the S&P 500. Passive funds can often outperform active funds during market upswings, but active funds can offer better downside protection during market downturns.Other options include target-date funds, which typically shift assets automatically from stocks to bonds as the investor approaches retirement age.
Other options include target-date funds , which typically shift assets automatically from stocks to bonds as the investor approaches retirement age.» MORE: How taxes on stocks work
» MORE: » MORE: How taxes on stocks workCreating a diversification strategy
Creating a diversification strategyCreating a diversification strategy can be tricky, especially if you don’t have the time, skill or desire to research individual stocks or investigate whether a company’s bonds are worth owning. Talking to a qualified financial advisor can help.
Creating a diversification strategy can be tricky, especially if you don’t have the time, skill or desire to research individual stocks or investigate whether a company’s bonds are worth owning. Talking to a qualified financial advisor can help.Here's a diversified portfolio example that shows how diversification might look in your own portfolio.
Here's a diversified portfolio example that shows how diversification might look in your own portfolio.Next Steps
Next StepsHow asset allocation impacts your portfolio
How asset allocation impacts your portfolioExchange funds: One way to reduce concentrated stock risk
Exchange funds: One way to reduce concentrated stock risk How to invest in the S&P 500 About the authors Tiffany Lam-Balfour Tiffany Lam-Balfour Tiffany Lam-Balfour is a former investing writer and spokesperson at NerdWallet. Previously, she was a senior financial advisor and sales manager at Merrill Lynch. Her work has been featured in MSN, MarketWatch, Entrepreneur, Nasdaq and Yahoo Finance. Tiffany earned a finance and management degree from The Wharton School of the University of Pennsylvania. See full bio. James Royal, Ph.D. James Royal, Ph.D. James F. Royal, Ph.D., is a former NerdWallet writer. His work has also been featured in the Washington Post, New York Times and the Associated Press. See full bio. Elizabeth Ayoola Elizabeth Ayoola Elizabeth Ayoola is a Lead Multimedia Producer and Co-Host of the Smart Money Podcast. Her work has been featured in The Associated Press, The Washington Post, MSN, Debt.com, ESSENCE, The Knot, and POPSUGAR. See full bio.Helpful resources
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