Diversification in Investing: What It Is and How to Do It

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Investing plays a key role in long-term financial planning, especially where retirement is concerned. According to recent Gallup studies, 56% of Americans say they own stock, one of the most common ways to invest. Stock market investing is particularly attractive to many because it gives investors the opportunity to make money if share prices grow. Of course, investors can lose money if prices fall. This is precisely why diversification is so important.

Diversification means allocating your investments in a way that doesn't put all your eggs in one basket. It typically involves spreading your money among riskier investments that provide the opportunity for higher return and safer investments that reduce the chance for loss. Market risk comes with the territory in investing, but creating a diversified portfolio can help mitigate risk and balance your investments. Here's a closer look at why diversification matters—and how to diversify your investments.

Why Is Diversification Important in Investing?

Stock market investing can take many forms, from picking individual stocks to participating in an employer-sponsored 401(k). Either way, buying shares can give you an ownership stake in a variety of public companies. If you sell those shares for more than you paid, you'll turn a profit (known as capital gain). You can also lose money if prices fall and never rebound beyond the purchase price.

Diversification involves purchasing a variety of investments across different industries, geographic locations and economic sectors. It also looks beyond stocks, leveraging different asset classes to strengthen your portfolio in various ways (more on this shortly). The idea is to strike a balance between potential risks and returns.

If you don't think diversification applies to you because you don't have an investment account with a financial services company, think again: If you have a 401(k) or individual retirement account (IRA), diversifying the investments within those accounts is critical to growing and preserving your future retirement income.

Diversifying your investments makes for a more robust investment portfolio that's better positioned to weather market swings. If one group of your investments goes down in value, the hope is that you can soften the blow because you've still got other assets that are performing well. Putting too much of your money into one type of investment can be very costly if the market takes an unexpected turn.

There isn't a one-size-fits-all formula for creating a diversified portfolio. Every investor's financial situation, risk tolerance and long-term goals are different. That said, an experienced financial advisor can guide you in creating a balanced portfolio that's built to support your unique goals. Doing it yourself can get complicated as you try to find the right mix of high-risk and low-risk investments. What's more, financial experts generally recommend diversifying even further within different asset classes.

Common Diversification Terms

When learning about diversification, you'll likely come across these common investing terms:

  • Asset classes: Asset classes are types of investment that have similar characteristics. The three primary asset classes are stocks, bonds and cash. A balanced portfolio is one that has a mix of these asset classes.
  • Asset allocation: This refers to how your investments are spread out across different asset classes. Your asset allocation is generally shaped by your retirement timeline, financial goals and risk tolerance. Someone in their 30s, for example, may be comfortable taking on more risk than someone who's approaching retirement.
  • Alternative investments: This umbrella term refers to investments that are outside of the three main asset classes. They can help further diversify your portfolio and potentially net better returns, though returns are never guaranteed, and some of these investments are particularly risky. Alternative investments can include private equity, real estate, hedge funds, commodities, currencies and more.
  • Rebalancing: The asset classes within your portfolio can fluctuate in value over time. As such, your investments can become too heavily weighted in one area or too light in others. Rebalancing allows you to reset your portfolio and find an asset allocation that's aligned with your age, risk tolerance and goals.

How to Diversify Your Investments

There's no magic number when it comes to asset allocation. One rule of thumb is to hold 60% stocks and 40% bonds (bonds are considered less risky than equities, or stocks). Investment research firm Morningstar found that portfolios structured in this way have earned an average annualized return of 10% over the past decade. However, as you near retirement, this recommendation usually shifts so you can safeguard your money in lower-risk investments.

The following investment categories lend themselves to built-in diversification:

  • Mutual funds: A mutual fund is an investment vehicle that pools money from participating investors. A fund manager then invests in a wide range of different assets, providing some degree of diversification. An index fund is a type of mutual fund with holdings that are tied to popular stock indexes, such as the S&P 500; they're passively managed, so fees are generally on the lower end.
  • Exchange-traded funds (ETFs): An ETF is similar to an indexed mutual fund in that it's passively managed and made up of a mix of securities that mirror a market index. The main difference is that ETFs' values change throughout the day rather than at the end of trading each day. This allows investors to respond more quickly to changing market conditions.
  • Target date funds: Also known as lifecycle funds, these are actively managed mutual funds that automatically take on less risk the closer you get to your target date. It's a hands-off approach that allows fund managers to rebalance and diversify based on the timeline you establish for your investment goals. Target date funds can be particularly useful for retirement saving.

The Bottom Line

Diversifying your investments among various asset classes can help you mitigate risk and is important to a long-term investment strategy. If you're not sure where to start or whether your investments are already diversified, it's wise to consult a financial advisor or your company's 401(k) representative (if that's where most of your investments are).

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