What is Diversification in Investing?

Diversification is a process that aims to reduce the risks associated with investing by spreading available dollars across and within asset classes. The idea is to not put all your eggs in one basket. For example, if you were an Apple fanatic, you might want to own Apple stock.

If you allocate all of your investing dollars to Apple stock alone, you are taking on more risk than necessary. Reason being is that 100% of your investing portfolio is tied to Apple stock. If Apple stock goes up, your entire portfolio goes up. But, if the stock goes down, your entire portfolio goes down.

Instead what you could do is add other investments to your portfolio. For sake of example, let's say that you added 24 more stocks to your portfolio. The performance of your portfolio is now dependent upon a total of 25 stocks as opposed to relying solely on Apple's stock.

By spreading your dollars across 25 stocks as opposed to one, you lower your exposure to risk. It is hard to predict which companies are going to perform well in the future, but owning a mix of assets increases your chances that some of the assets you own will perform well even if others don't.

The first way to diversify is by asset class. There are many different asset classes to invest in, but most investors will diversify their portfolio across bonds, individual stocks, funds, and cash.

1) Bonds - Bonds are loans that you make to a corporation or government. In exchange for buying a bond, you get interest payments and the face value of your bond back at maturation. Bonds are often considered to be more stable than stocks and are typically used in a portfolio to offset some of the volatility that stocks have.

2) Individual stocks - Stocks represent a share of ownership in a publicly traded company. Stocks are more volatile than bonds but offer higher returns. Some investors choose their own individual stocks they want in their portfolio. However, this is a challenging task for many investors, which is why funds exist.  

3) Funds - Funds, such as index funds and mutual funds are a collection of stocks and/or bonds. You can buy a share of a fund to get exposure to the underlying assets that the fund owns. Funds are already diversified and are often used by investors who do not want or do not know how to choose individual stocks or bonds.

4) Cash - Cash is not inherently an investment itself, but some investors will allocate a small percentage of their portfolio towards cash as it is more stable than other investments. Cash can be held in a high yield savings account to earn a more competitive interest rate than a standard savings account.  

The way to diversify your portfolio among these assets primarily depends upon two factors - your risk tolerance and your time horizon.

1) Risk tolerance - Your risk tolerance is simply the amount of risk that you can stomach as you invest. For example, if the thought of watching your investing portfolio going down in value makes you sick, you have a lower risk tolerance.

On the flipside, if it does not bother you that much when your portfolio goes down in value, you have a higher risk tolerance. As you create a diversified portfolio, you want to build it in such a way that it aligns with your risk tolerance.

For example, let us assume that you have a high risk tolerance. This means that you are willing to take more risk with your investments in exchange for the possibility of higher returns. A diversified portfolio for you might look like a 90/10 split between stocks and bonds, respectively.

On the flipside, you might have a lower risk tolerance. Your diversified portfolio might be a 60/40 split between stocks and bonds, respectively. This portfolio would have lower returns which means you might have to invest more money or invest for a longer period to reach your goals.  

However, the advantage is that this portfolio would be less volatile than a high risk tolerance portfolio. You might also have a risk tolerance that is somewhere in the middle. Your diversified portfolio might look like a 75/25 split between stocks and bonds respectively.

2) Time horizon - Beyond your risk tolerance, you also need to consider your time horizon as you diversify your assets. Your time horizon is the amount of time you have until you need access to your money. For example, say that you are 30 years old and want to invest for your retirement at 65 years old.

This gives you a 35 year time horizon. The general rule of thumb is that the longer your time horizon, the more risk you can afford to take. If you are 30 years old and plan to invest for the next 35 years, you can afford to take on more risk even if you don't have a high risk tolerance.

During this period, it is inevitable that the assets you invest in will fluctuate in value. However, since you have a long time horizon, your assets have the time to recover from losses or even crashes. This allows you to invest more of your portfolio in more volatile assets in exchange for higher returns.

As you get started, you might build a diversified portfolio that has a 90/10 split between stocks and bonds, respectively. Some younger investors also choose to allocate 100% of their portfolio towards stocks. However, as you get older, you will not be able to take on as much risk.

Say that you are now 55 years old. If you hold 100% of your portfolio in stocks and the stock market crashes, you might not have enough time to recover from that. For this reason, you might start to diversify more of your portfolio to assets with less volatility, such as bonds.

You might convert your portfolio to have a 70/30 split between stocks and bonds, respectively. Even if your risk tolerance is still high at this age, you might not be able to afford to take the risk of more volatile assets. Keep in mind this is purely a hypothetical example.

You might have other investments outside of a standard retirement portfolio that you can take into account when deciding how to diversify your portfolio. Working with a competent financial advisor can help you make a more informed decision.

Beyond diversification in different assets, you can continue to diversify within each asset class itself. For example, you might decide that 90/10 split between stocks and bonds is how you want to diversify between different assets based upon your risk tolerance and time horizon. You can continue to diversify by holding different types of stocks and bonds.

1) Market cap - A market cap is simply the size of a company and is calculated by multiplying the total number of shares by the price per share. Large cap stocks are stocks of big companies. These companies tend to be more stable than small or mid cap companies. Small or mid cap companies are not as stable as large cap companies but do allow the potential for more growth.  

2) Industries - Holding stocks in a mix of industries is another way to diversify. Certain types of industries will perform well while others do not. If you spread your stocks among several different industries, it is another way to lower risk.

3) Location - You can also diversify your stock selections by holding stocks in different locations. The main locations are the US, developed countries, and emerging markets. At times, holding stocks in various locations may be beneficial as companies outside the US may perform differently than companies in the US.

1) Bond duration - A bond's duration is based upon its maturity. For example, a short term bond might have a one year maturity, whereas a long term bond might have a twenty year maturity. Longer term bonds tend to offer a higher return as they are riskier to the investor. You could hold a mix of short, medium, and long term bonds to diversify if it makes sense to do so.

2) Type of bond - Bonds are issued from either the government (federal or local municipalities) and corporations. You could a mix between corporate, and government bonds to provide another layer of diversification.

3) Bond quality - Bonds are given a credit rating that tells investors how safe the bond is. A bond with a higher credit rating will provide a lower return as the risk is lower for the investor. A bond with a lower credit rating will provide a higher return as there is more risk to the investor.

Diversification is simply a risk management strategy as you invest. It does not protect you from losing money. It is instead designed to cushion the blow. For example, say that you did not have a diversified portfolio and only owned three stocks.

Say these stocks were in the same sector and that sector took a hit resulting in a 15% loss in the stocks value. If your portfolio were originally worth $10,000, it would now be worth only $8,500. However, say that you diversified beyond these three stocks and held a total of 30 stocks.

When these three stocks go down in value, your total portfolio would be less effected since you own other stocks. It might only go down by a few percent depending upon how much of your portfolio was allocated to those three stocks.

It is also important to understand that a drop in the value of your assets is different than a financial loss. For example, if you have a portfolio worth $100,000 and it drops in value by 10%, you would then have $90,000. On paper this is a financial loss.

However, if you do not sell your investments, you did not lose anything. If you hold onto your investments, there is a good chance they will recover from the loss given enough time if you have a diversified portfolio.

For most investors, diversification is necessary. There are some investors who do not diversify as much as others. For example, certain investors might solely invest in assets like real estate or businesses that they plan to grow. These individuals are often more specialized than the average investor.

As you diversify, you sacrifice the possibility to experience exponential returns from a single asset. However, for most investors it is too risky to try to hit a home run from a single investment. By spreading dollars across asset classes and within the classes themselves, you can lower risk while still having the possibility to earn good returns over time.

Although diversification is important, it is equally important to make sure that you are not overdiversified. Over diversification occurs when adding additional investments to your portfolio lowers your expected return more than it lowers your exposure to risk.

For example, say that you held a stock index fund that primarily owned large cap stocks. It would not be beneficial to add another fund that is like the one you already own. Just because a diversification option exists, does not mean it will be beneficial to you.

For example, there are large cap stocks, mid cap stocks, small cap stocks, US stocks, emerging market stocks, developed country stocks, and stocks in many different industries. Diversification does not mean that you must hold all of these types of stocks in your portfolio.

Unfortunately, there is not an exact rule that tells you when you are overdiversified. However, if you are holding lots of similar assets, lots of individual stocks, or do not understand why you own an investment, it can be worthwhile to evaluate if you have an overdiversification problem.

An easy place to create a diversified portfolio is through a robo advisor. A robo advisor is a digital advisor that uses algorithms to build a portfolio for you. When you sign up for a robo advisor, it asks you a series of questions that it uses to gauge your risk tolerance and time horizon.

Based upon these answers, the robo advisor will recommend a portfolio for you to invest in. All you must do is contribute to the portfolio and the digital advisor does the rest. A robo advisor is not a full service financial advisor.

However, it can be a beneficial tool to help you start investing if you lack experience as it manages diversification for you. Keep in mind that it is best to move away from a robo advisor to a financial advisor as you build more wealth. A financial advisor is equipped to build a comprehensive financial plan for you, where as a robo advisor is not.

If you want more control over your portfolio, you can open an investing account through an online broker. An online broker will allow you to research individual stocks, investment funds, and bonds that you can use to create your diversified portfolio.  

The bottom line is that diversification is a process that aims to reduce the risks associated with investing by spreading available dollars across and within asset classes. For most investors diversification is a key financial concept to understand to build wealth.