Because assets perform differently in different economic times, diversification smoothens your returns. While stocks are zigging, bonds may be zagging, and CDs just keep steadily growing. In effect, by owning various amounts of each asset, you end up with a weighted average of the returns of those assets. Diversification reduces asset-specific risk — that is, the risk of owning too much of one stock such as Amazon or stocks in general relative to other investments.
So diversification works well for asset-specific risk, but is powerless against market-specific risk. Finally, cash in a savings account can also give you stability as well as a source of emergency funds if you need it.
If you want to expand beyond this basic approach, you can diversify your stock and bond holdings. For bonds, you might choose funds that have short-term bonds and medium-term bonds, to give you exposure to both and give you a higher return in the longer-dated bonds. For CDs, you can create a CD ladder that gives you exposure to interest rates across a period of time. Some financial advisors even suggest that clients consider adding commodities such as gold or silver to their portfolios to further diversify beyond traditional assets such as stocks and bonds.
And if all this sounds like too much work, a fund or even a robo-advisor can do it for you. A target-date fund will move your assets from higher-return assets stocks to lower-risk bonds over time, as you approach some target year in the future, typically your retirement date.
Similarly, a robo-advisor can structure a diversified portfolio to meet a specific goal or target date. Diversification offers an easy way to smoothen your returns while potentially increasing them as well.
And you can have a variety of models for how diversified you want your portfolio to be, from a basic all-stock portfolio to one that holds assets across the spectrum of risk and reward. How We Make Money. Editorial disclosure. James Royal. Written by. Bankrate senior reporter James F. Royal, Ph. Edited By Brian Beers. Edited by. Brian Beers. Brian Beers is the senior wealth editor at Bankrate. He oversees editorial coverage of banking, investing, the economy and all things money.
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I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Part Of. Stock Market Basics. How Stock Investing Works. Investing vs. Managing a Portfolio. Stock Research. Investopedia Investing. Table of Contents Expand. What Is Diversification? Understanding Diversification. Different Types of Risk. Problems with Diversification. What Does Diversification Mean in Investing? What Is an Example of a Diversified Investment? The Bottom Line. What Is Diversification in Investing?
Key Takeaways Diversification reduces risk by investing in vehicles that span different financial instruments, industries, and other categories. Unsystematic risk can be mitigated through diversification while systemic or market risk is generally unavoidable. Balancing a diversified portfolio may be complicated and expensive, and it may come with lower rewards because the risk is mitigated. By diversifying, you're making sure you don't put all your eggs in one basket.
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Diversification is the act of spreading your wealth over different types of investments so that it's not concentrated in just one place. A well-diversified portfolio will have funds invested across a variety of different asset classes , such as cash, equity, bonds, commodities, and property.
Diversification reduces risk by making sure your money is spread over a variety of investments, so, if one of them suffers a negative effect, only a small portion of your wealth loses value. If you were to keep all your funds invested in just one area, you would be increasing the risk of a single factor impacting the entirety of your money. By adopting a diverse strategy, you can ensure your portfolio is much less likely to underperform or lose value. However, diversification is not just a case of splitting your money between different stocks or placing half your funds into a different savings account.
The aim is to spread your wealth over different asset classes so that you have a strong, balanced investment portfolio.
As each asset class is impacted by market factors in different ways, a diverse set of investments is much more likely to remain stable. For instance, property investments traditionally do well when interest rates are rising, while fixed-rate investments, such as bonds, are susceptible to high interest rate environments as they are static - causing them to fall behind the market rate. If your portfolio leant too heavily on bonds, you would see a bigger loss of value than if your money was split between bonds and some property interests, which could help to balance out the negative impact.
If you're looking to build a well-diversified portfolio or you're aiming to expand upon a few investments that you've already made, it's important to focus on diversifying your interests so that you can create the right balance and reduce the level of risk.
Below, we'll take you through how to create a good investment portfolio in four essential steps. The first step to creating a diverse portfolio is to identify what your investment goals are.
Consider key points like whether you're looking for slow and steady or quick growth, how long you're willing to invest for, and which types of investment you would be comfortable with, as this will build a clearer picture of what type of asset classes you should be looking at for your portfolio.
You should also consider other details, such as your age, dependents, and other financial commitments before making a final decision. While the main aim of diversifying is to protect your wealth, it's also important to get a balance between low and high-risk asset classes. For example, if you were willing to invest for the long term and you identified your main objective as protecting your wealth while experiencing a sensible rate of growth, you would probably need to look at low-risk assets like ISAs, lower-risk peer-to-peer lending platforms , and bonds to form the core of your investments.
You could add some equity or property investments to further diversify your portfolio and guard against both inflation and interest rate rises.
On the other hand, if you're out to make money as soon as possible, you may wish to diversify your portfolio with riskier asset classes. This might mean that you lean more heavily into the likes of shares, property, commodities and high-risk P2P platforms over investments that offer a lower rate of return. This option is often more popular with younger investors who have much less on the line should some of their assets fail. If you're unfamiliar with the main types of investment on the market, be sure to read our guide to asset classes to find out the strengths and weaknesses of each one.
Should you still feel unsure about choosing the right combination of assets, it's often worth seeking advice from a financial advisor who will be able to provide professional guidance. Should you already have a number of investments — especially in stocks — a good way of checking whether your portfolio is diverse enough is to review its performance and see whether it matches the way the markets have performed over the past few years.
If there is a strong correlation, it implies that your portfolio is not fully diversified, as having a variety of investments across asset classes and investments should ensure your performance deviates from the market pattern. With a well-diversified portfolio, your investment should not follow the wider market too closely as you'll have a mix of assets that are chosen to respond differently to both positive and negative market factors.
While choosing to make a series of investments over a variety of asset classes is a good start, to really diversify your portfolio you will need to take it a step further and make sure your investments are spread out within each asset class. This extra level of diversification will further protect your wealth from market factors that may have a negative impact. Firstly, consider investing in a selection of different sectors to make sure that your money is not hit by a downturn in one industry.
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