The Surprising Truth About Diversification

Diversification is often touted as the most important strategy in an investor’s toolkit. But if you read the fine print in your investment or financial education materials, you’ll often see this line:

“Diversification does not ensure a profit, nor does it protect against loss of principal.”

When some of the investments in your diversified portfolio are gaining during a particular market environment and a few others aren't keeping up (or are losing value), everything might actually be going according to plan.

How can that be?

Let’s dive further into what diversification is and what it isn’t.

What Is a Diversified Portfolio?

Diversification simply means spreading your money over multiple asset classes (categories of investments) that respond differently to market changes.

At a high level, those types of asset classes include stocks, bonds and cash equivalents like money markets. Each asset class has its own characteristics: Stocks and bonds may perform differently when the economy is booming or slowing down, when interest rates rise or fall or when political events make headlines.

Investing your money with different financial institutions or product types (stocks, mutual funds, exchange-traded funds, etc.) is not diversification. These variations won’t help if your investments all act the same when markets move.

Diversification as an Investment Strategy

Think of diversified portfolios as a way to spread out the risk of your investments. That should mean less volatility overall in your portfolio. While it sounds complicated, investors can start diversifying their portfolios the moment they begin investing.

If a portfolio is not diversified, it runs the risk of losing too much of its value if one asset dips. While no portfolio is without risk, a diversified portfolio has enough variety that not all value is lost when one investment declines.

Part of the secret of a diversified portfolio is creating a mix of low-correlation investments. A portfolio full of high-correlation investments is less diversified; if one asset begins to decline, the others are likely to as well.

Correlation is measured historically, meaning that how closely assets are linked can change over time. The historical data and performance can be used to help inform your current investment strategies.

How To Diversify Your Portfolio

Diversified portfolios will look different based on your risk tolerance and timeline, but they’re generally a mix of these investments.

• Stocks are often the highest risk or most aggressive element of an investor’s portfolio. Domestic stocks will not always carry the same types of risks as international stocks, meaning including both in a strategy could help spread out your risk.

• Bonds are often considered less risky or volatile than stocks. Some provide the potential for income, which can provide investors with a buffer against less-predictable assets.

• Cash equivalents

  like money markets, certificates of deposit and other short-term investments offer the least growth potential, but they offer liquidity and have lower risk.

These elements are the most common in investors’ portfolios, but they are by no means the only assets a person can invest in. Portfolios could also include alternative investments such as real estate investment trusts (REITs), commodities, sector funds or asset allocation funds.

It Looks Like It’s Diversified, But …

A portfolio can have a variety of underlying investments but still not be properly diversified.

Diversification should also go beyond the general categories of stocks, bonds and cash equivalents. Each of these can be split further into more specialized categories.

Risk Management

Some investments have more growth potential than others, so why not stick with all stocks, for instance? Because growth can go hand in hand with risk. For example, emerging markets stocks were up 18.31% in 2020, then down –20.09 in 2022.¹

Most investors aren't comfortable with such uncertainty, but research shows that no asset has a repeatable performance pattern. Owning different asset classes, however, can help prepare you for various market conditions and may help provide more consistent, less volatile returns over time.

Diversified portfolios have the potential to benefit from some of the big gains (but not all) of their underlying assets and experience some (and not all) of the big losses. The end goal is a smoother pattern of performance and less anxiety for you.

Can Portfolios Be Over-Diversified?

Yes, portfolios can be over-diversified. For example, if you add a new asset to your portfolio that’s too similar to another, you could suddenly change your overall risk profile—either exposing you to too much risk, or lowering your growth potential. That can throw a portfolio’s balance out of whack.

That’s why it is important to perform regular checkups on your portfolio.

One Option: All-in-One Diversification

Diversifying your investments may seem complicated if you try to research and select each type of asset on your own. Most mutual funds allow you to spread your money across securities in a specific category.

You can go beyond that with a fund-of-funds investment, which provides a mix of funds that cover multiple asset categories in a single product. More importantly, fund managers will carefully select and monitor the investments in these portfolios for their shareholders.