Diversification is an investment strategy in which you invest across multiple types of assets to reduce risk. It’s a way of acting on the adage “Don’t put all your eggs in one basket.” Simply owning a bunch of stocks isn’t enough. To build a diversified portfolio, you need to invest in multiple stock market sectors, as well as other asset classes, such as bonds and cash equivalents.
Building a diversified portfolio may sound complicated if you’re a beginning investor, but it’s not as complex as it sounds. Learn how to diversify your investments and how much diversification is enough.
- Diversification is a strategy of investing in multiple assets to reduce the risk in case any one investment fails.
- To achieve diversification, you typically want a mix of stocks, bonds, and cash assets.
- Overdiversification occurs when you invest in so many different assets that you reduce your returns.
What Is Portfolio Diversification?
Portfolio diversification is a long-term strategy that involves spreading money across a wide mix of assets to reduce the risk of volatility. However, diversification isn’t just about the number of investments you have.
It’s important to invest across multiple types of assets, such as stocks, bonds, and cash equivalents, including certificates of deposit (CDs) and money market funds.
To understand how diversification works, take this example of a stock-only investment. Suppose you were to invest $100,000 in just one stock during a year in which the stock market was expected to deliver 8% returns. As a result of this decision, you could expect anywhere from an 80% loss to 96% gains, according to an Edward Jones analysis.
Investing in 15 stocks during the same period would significantly reduce your range of outcomes. By diversifying with 15 stocks, you could expect anywhere from a 3% loss to a 19% gain. Though your potential returns would be lower, you’d also significantly lower the risk of losing almost all of your money.
Why Diversification Matters
Owning a portfolio that’s overly concentrated in any one investment amplifies the risk if the investment fails. Having a portfolio that’s highly concentrated in your own employer’s stock is a classic example. Along with the risk that the stock market will drop, there’s the risk that your company will fail. In that case, the risk is twofold: A large chunk of your investments would become worthless right as you also lose your job, as happened to former Lehman Brothers and Enron employees.
To achieve diversification, you need to do more than just invest in many different stocks alone. Ideally, you’d want to have:
- Asset diversification: A mix of stocks, bonds, cash equivalents, and possibly alternative investments.
- Sector diversification: Investments across the 11 different stock market sectors.
- Geographic diversification: Both domestic and international investments.
- Time, or temporal, diversification: A mix of investments that allows for multiple outcomes over a long time horizon.
The 3 Main Asset Categories
There are three major asset categories that a diversified portfolio should include:
- Stocks: These are also known as "equities." A stock represents an ownership stake in a publicly traded company. You can make money through capital gains or if the company issues dividends. Returns aren’t guaranteed, so you can lose money if the share price falls. You can also invest across many different stocks with a mutual fund or exchange-traded fund (ETF).
- Bonds: These securities are issued by corporations or governments that are seeking to raise money. Investors typically profit from regular interest payments, and they receive repayment of their principal when the bond reaches its maturity date. Bonds tend to offer less risk but also lower returns than stocks.
- Cash funds: This class is represented by cash and short-term deposits. They’re extremely low-risk, but they offer much lower returns than stocks and bonds. They tend to be a good option for short-term needs.
Diversification can’t reduce systematic risk or threats to your portfolio associated with the overall economy.
Diversification Using Alternatives
Some investors seek to diversify beyond traditional asset classes. Adding alternative investments like real estate, commodities, or cryptocurrency can provide additional diversification.
Risks of Overdiversification
There’s also a risk in too much diversification. Overdiversification occurs when you spread your money across so many different investments that you reduce your returns without significantly reducing your risk. Pursuing too much diversification can make it hard to keep track of your investments and lead you to invest in things you don’t understand. It can also result in higher fees, particularly if your portfolio is professionally managed.
One common overdiversification mistake is to invest in overlapping assets. Suppose you own an S&P 500 index fund. You want to diversify beyond the S&P 500, so you add a so-called total stock market fund to gain exposure to the entire U.S. stock market. You wouldn’t get much extra diversification from holding both, because S&P 500 stocks account for about 80% of the U.S. stock market by market capitalization.
How Much Diversification Is Enough?
There’s no magic formula for how much diversification is enough. You could own hundreds of stocks but still not be properly diversified if they’re concentrated in just one or two sectors. Here are some general guidelines.
How Many Stocks Should You Own?
Benjamin Graham, the pioneer of value investing and Warren Buffett’s mentor, recommended owning at least 40 stocks. However, modern-day recommendations vary based on how much of your portfolio consists of individual stocks. That’s because it’s possible today to achieve diversification through mutual funds and ETFs.
As a general rule, you don’t want any single investment to account for more than 5% of your portfolio. Note that this doesn’t apply to mutual funds and ETFs, because they can include hundreds or even thousands of investments.
How Many Mutual Funds Should You Own?
You often can adequately diversify with a single target-date fund (TDF), which is a type of mutual fund that’s common in 401(k) plans. A target-date fund offers a mix of stocks and bonds that’s allocated according to the investor’s planned retirement date. They start with a higher concentration of stocks, then shift more to bonds as your retirement date gets closer.
Otherwise, you could diversify by owning just three funds: a total stock market fund that invests across the U.S. stock market, an international stock fund, and a total bond market fund.
How Many Bonds Should You Own?
A single total bond market fund can give you wide exposure to both government and corporate bonds with different maturity dates. For example, Vanguard’s Total Bond Market ETF (BND) invests in over 10,000 U.S. government and corporate bonds.
Determining the correct bond allocation depends on your age, when you want to retire, and your risk tolerance. If you’re risk-averse or near retirement, your bond allocation should be higher than it would be for younger, more aggressive investors.
Traditionally, financial professionals recommended subtracting your age from 100 to get your proper bond allocation. For example, a 40-year-old following this guideline would have 60% stocks and 40% bonds. But as life expectancies have gotten longer, many now recommend subtracting your age from 120.
What to Watch Out for While Determining Portfolio Diversification
It’s important to keep the big picture in mind when you’re determining how much diversification is enough. Your goal is to minimize the risk to your finances in case any single investment fails, while still earning ample returns.
Stocks fuel your portfolio’s growth, while bonds offer stability. Your exact mix depends on your time horizon and risk tolerance. You can get instant diversification through mutual funds and then add individual investments that fit your goals. Alternative assets, like cryptocurrency, can add diversification to your portfolio and may allow you to earn outsize returns, but for a conservative investor, the additional diversification likely wouldn’t be enough to justify the increased risk and volatility.
Frequently Asked Questions (FAQs)
How do you measure diversification in a portfolio?
There’s no single metric. However, to have sufficient diversification, you want assets that have little or no correlation, or those that have a negative correlation, meaning that they move in opposite directions. Look at the correlation coefficient of any two assets, which ranges from +1 to -1. A negative number shows that they have a negative correlation. A +0.0-0.4 suggests a low correlation.
How does diversification protect investors?
Diversification protects investors from the risk of any single investment failing. Investing across different asset classes does this further, hedging against the risk from a prolonged stock market downturn or trouble in a specific sector, for example.