Takeaways
- Diversification is an investment method of allocating investment funds to many investments.
- Diversification can be achieved by investing in stocks, bonds, currencies, and other asset classes.
- Diversification trades a lower potential investment reward for decreased investment risk.
- Investors can invest in diversified investment funds or by choosing many investments.
- Diversification quality is maximized through statistical analysis and can be optimized.
What is Investment Diversification?
Diversification is an investment strategy that involves purchasing investments across multiple asset classes and many securities within those classes to reduce investment risk in a portfolio. Diversification is a risk management strategy for an investment portfolio that seeks to broadly distribute investment risk throughout a portfolio instead of relying on single asset investment risk.
The investment theory behind diversification is that a diversified portfolio will, on average, generate higher long-term investment returns and decrease the risk of owning specific securities than single investment portfolios.
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Types of Diversification
Some of the most common types of asset classes to invest in are:
Cash or Cash Equivalents: This includes the funds in your savings or checking account. Investments in cash and cash equivalents are generally considered low risk, especially capital held at FDIC-insured institutions.
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Personal finance experts advise building an emergency fund and slush fund, and you can optimize your returns on these funds by investing in high-yield savings accounts. These accounts allow you to earn interest income with low investment risk.
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Stocks: Investing in stocks or equities is riskier than investing in cash or cash equivalents. However, when you own stock, you own a piece of that business and potentially a piece of associated future income streams. Stock investors earn returns through capital appreciation and dividend income. Investing in the stock market can increase your net worth quickly, but finance professionals argue to solidify your finances before investing in stocks.
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Bonds: Bonds, or Fixed Income securities, pay investors interest on their bond when they purchase a bond or lend to a company or government that has issued bonds. Bonds can help solidify fixed-income solutions and offer investors varying degrees of risk. For example, interest on a junk bond is typically higher than on a AAA-rated corporate bond.
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Real Estate: Real estate is one of the most common asset classes. In the second quarter of 2023, roughly 66% of Americans lived in their own house 1. If you are a homeowner, you are invested in real estate. Investing in real estate broadens your investing aperture, exposing your portfolio to an entirely new class of assets.
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Advantages of Diversification
Diversification can vary from one investor to the next. For example, you may have a different investment time horizon, risk appetite, or financial goals, which changes your degree of portfolio diversification compared to another investor. The advantage of diversification is that it allows you to broadly distribute your investment capital to optimize for returns while reducing investment risk.
Smart Tip:
Stock and Bond Mutual Funds and Exchange Traded Funds (ETFs) can provide diversification with one investment. Each fund offers diversification within the class of stocks or bonds based on the fund’s investment objectives (e.g., S&P 500 Index).
Investment Diversification
You can broaden your investment diversification by expanding your investments within the asset classes. By dividing asset classes into subsections, you can pool pockets of investable capital into more specific areas. For example, you can break down each asset class by industry, geography, creditworthiness, company size, or type of issuer.
Stock Portfolio Diversification
Industry: Each industry within the publicly traded stock markets, such as the NASDAQ or NYSE, has its level of risk and reward profile. Certain industries have higher growth (more on that below), and others are more cyclical. The eleven stock market industry sectors are generally categorized as energy, materials, industrials, utilities, healthcare, financials, consumer discretionary, consumer staples, information technology, consumer services, and real estate. Within each sector, companies vary in size and scope of their business operations.
Company Size: Stocks are stratified by their market capitalization, which is the total value of a company’s outstanding shares2. Market capitalization is the total number of outstanding shares multiplied by the current price per share. Market capitalization gives investors a sense of how large these companies are and how liquid or easily tradable their shares might be.
- The five market size categories are:
- Mega-Cap = $200 Billion or more
- Large-Cap = $10 Billion to $200 Billion
- Middle-Cap = $2 Billion to $10 Billion
- Small-Cap = $250 Million to $2 Billion
- Micro-Cap = $250 Million and below
Style: Not only are stocks categorized by industry and company size, but they can also be further stratified by what investors call value stocks or growth stocks.
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- Value Stocks are companies that are currently undervalued by the market relative to their intrinsic value. This mismatch between intrinsic value and current share price allows investors to earn a return. Investors buy these stocks hoping the market will recognize their true value, and this appreciation in stock price will produce investment returns.
- Growth Stocks are companies that are growing rapidly, and investors believe will continue to grow at a rate that outpaces the average prevailing market growth rate. Investors tend to be willing to pay higher prices for this growth, which usually comes in the form of revenue, market share, or customer acquisitions
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Bond Portfolio Diversification
Real Estate Portfolio Diversification
Property Type: Real estate investments come in all shapes and sizes. To diversify your real estate investments, you can invest in multifamily, commercial, and REITS. Multifamily properties include two or more units under a single roof and are great investment opportunities for beginner real estate investors. Commercial properties, such as shopping centers and office buildings, are typically purchased by more seasoned investors. Real estate investment trusts (REITs) own many properties under a single portfolio. REITs can be invested in on public exchanges, offering quick portfolio diversification.
Property Size: Property sizes and costs can vary significantly. Purchasing properties across an array of building sizes may boost your diversification.
Geography: Owning properties in the U.S. may be an initial approach, but expanding to real estate in developing countries can also be helpful.
Homeownership: Owning your home may be just enough real estate exposure for your personal portfolio. Learning how to pay off your home early can boost your home equity and provide your portfolio the exposure it needs to be properly diversified.
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How to Build a Diversified Portfolio
Constructing a diversified portfolio should be done in the context of your financial goals. Finance professionals, such as financial advisors, can help you strategize about where to diversify your current asset mix, no matter how far you are into your financial journey. Investing in diversified funds – either stock or bonds – can take the guesswork out of where to start. Once you have a growing portfolio, it is vital to regularly monitor your investments for overlapping exposure that could be invested to broaden your diversification mix.
You can make diversification as complex or as simple as you like. Some investments can help you reach a high degree of diversification without much heavy lifting. If you take a "Do-It-Yourself" approach to diversification, selecting an Exchange-Traded fund (ETF) or mutual fund can be an excellent starting point. You can find funds that invest broadly, like funds based on the S&P 500 or other indexes. While these funds invest in stocks, you can find more diversification by placing funds in diversified bond ETFs. These will help give you a mix of stocks and bonds.
Add to your diversification by investing in target-date funds that help you invest for retirement. These funds automatically shift their asset allocation based on the target date, typically aligned with your target retirement date. The farther out from retirement, the more the funds invest in stock but automatically shift to holding more bonds and cash as the target date approaches.
Mutual funds, exchange-traded funds, and target-date funds are relatively low-cost options to juice your diversification quickly. Consider meeting with a finance professional, such as a financial advisor, to calibrate your diversification even more.
Is Diversification a Good Idea?
For the average investor, diversification is a smart money move. Diversifying your portfolio will reduce the risk of only owning a handful of investments in stocks, bonds, or real estate and distribute investment risk across your portfolio. However, diversification trades investment returns for a substantially reduced risk profile. As a result, you trade the preservation of your investment principal for potentially lower investment yields.
Some professional investment managers, however, purposefully do not diversify. These investment funds are specifically created to take heavily concentrated investments in industries, industry categories, and geographic regions. Investing in these funds will broaden the distribution of your investment risk.
Smart Summary
Diversification helps to reduce asset-specific risk and market risk in your portfolio. Decreasing risk as you build your investment portfolio will let you systematically add more risk (and hopefully returns) over time. Being cognizant of diversification early in your investment career will help you plan for retirement and get you on solid financial footing. Diversifying your investments early is a smart money move.
(1) St. Louis. Fed. Homeownership Rate in the U.S. Last Accessed October 19, 2023.
(2) FINRA. Stock Market Cap Explained. Last Accessed October 24, 2023.
(3) BMO. An explanation of bond ratings. Last Accessed October 24, 2023.
