Why Diversification in Investing Can Make or Break Your Strategy
You've probably heard it's important to diversify in investing, but you may not understand what that means in practice or how to implement it with your own investments. Let's explore what makes diversification vital for a well-rounded investing strategy and how you can take advantage of it.
What is diversification in investing?
Diversification in investing means combining different types of assets in your portfolio, so you can spread them across higher and lower levels of risk while achieving the best returns possible. When your investments are performing across multiple asset types and classes, your entire portfolio isn't completely tied to the successes or shortcomings of any particular asset type or group.
Stocks, bonds and funds are all different types of investments with different levels of risk—it's important to mix them up appropriately to meet your financial goals.
Understanding risk tolerance
Risk tolerance refers to how much risk you're willing to take on in your investments. The risks involved in investing come primarily from market volatility, the normal ups and downs that occur due to changes in the economic environment or within a particular company.
One of the most common ways a financial advisor might assess this metric is by having you fill out a risk tolerance questionnaire. These questions typically ask how you'd react in a set of scenarios—say, if a particular investment fell by 15% or another rose by 10%. Your answers will help the advisor understand how much risk you're comfortable with so they know how best to invest for you.
Not all levels of risk are right for each investor. Your unique risk tolerance level will be a driving factor in what a good diversification strategy looks like for you.
Stocks and bonds
These are the two most common types of investments that people include when they diversify their portfolios. Stocks are generally considered a higher risk than bonds, but with that comes greater potential for reward.
When you buy a stock, you're buying into the current operations of a company. While the rate of return isn't guaranteed, it can be very good if the stock performs well.
There are also varying levels of risk within stocks. For example, startups tend to be seen as higher-risk. Then there are more stable blue-chip stocks, which are companies with steady growth and a history of good returns over long periods of time.
Bonds, on the other hand, are loans made by the investor to a borrower, usually a company or government agency. They often pay investors a fixed interest rate backed by a promise from the borrower, although some have variable interest rates. This setup means there's much less volatility with bonds, because investors' returns aren't as subject to market conditions as they are with stocks.
Most investment portfolios aim to balance stocks with bonds, because bonds are typically more stable and have low fluctuation. Stocks tend to offer a greater return over the long term, while bonds sometimes outperform stocks in the short term. By investing in a combination of both stocks and bonds, with appropriate risk levels for your tolerance, your portfolio's performance may be less effected if one category takes a hit.
Funds may offer ready-made diversification
Another way to diversify your stock investments is to choose a fund. Funds are curated for you by investment managers. These trained professionals diligently research each of the companies and holdings within their fund and balance out the lows and highs of these diversified investments.
The investment managers research each of the companies and holdings within their fund to achieve balance. There are index funds, which follow major market indexes, as well as actively managed funds organized by company size, type and sector.
Funds can be helpful because they often have diversification built in. You can also choose what types of funds align with your values. For instance, if you're environmentally conscious, there are funds that focus on socially responsible investment strategies or that don't invest in fossil fuels.
Taking time to rebalance
From time to time—or during major life changes, such as a new job, a new baby or a home purchase—it's important to take a look at your investments and make sure they match your current situation. This is called rebalancing your portfolio. Set up reminders to check in on your investment mix every year, or more frequently if circumstances change.
Diversification in investing helps you tailor your investments to your goals. Having a clear vision of what you hope to achieve is the first step in deciding how to diversify. Taking a look at investments and assets you already have is the second step. Figure out how well these match your financial goals and risk tolerance, and consider talking to a trusted financial advisor who can walk through everything with you.
