Investing involves risk, and a diversified stock portfolio can help you limit that risk. Diversification reduces the risk of your investments by finding assets with a low correlation to each other. For example, two stocks in the same industry – such as airlines and oil companies – would have a high correlation to each other.
When it comes to investing, most people have heard the saying “Don’t put all your eggs in one basket.” This simple piece of advice is meant to warn investors against putting too much money into a single investment, because if that particular asset crashes, you could lose everything.
Experts generally recommend diversifying investments within each of the main asset classes: stocks, bonds and cash alternatives. Within those categories, they advise diversifying by market capitalization (small, mid and large companies), geography (domestic U.S. and international), and sector.
A person can also add diversification by dividing their money between short-term assets that focus on the preservation of their principal over the quest for high rates of return, and long-term investments that can take on more risk for the potential of higher returns. Those who don’t want to build their own portfolio might consider a target-date fund, which typically provides exposure to the three main asset classes, while adjusting its allocations over time.
Adding bond funds to your portfolio can provide income and an offset to stock market volatility. They have lower annual rates of return, but they can help mitigate the risk of losses in declining markets. To diversify your bond holdings, consider a variety of credit qualities, maturities and issuers. You can hand-select bonds or use an exchange-traded fund or mutual fund.
For the most effective diversification, it’s best to hold shares of many different companies and sectors. However, if you’d rather not research individual stocks, a target-date fund can be a good choice. These funds target a specific date in the future, usually retirement, and shift their asset allocation away from stocks toward safer investments over time.
Investing in broad index funds can add further diversification to an existing portfolio. These funds track market indices, and they offer a low cost way to generate returns while helping you reach your financial goals.
For example, investors might choose to invest in a fund that tracks the Nasdaq-100 or S&P 500, which would provide a diversified exposure to American companies. Alternatively, they might choose to look at international funds that focus on countries that have growing long-term economic potential.
Investors can find these funds online or through a robo-advisor, where they may benefit from lower fees and automatic rebalancing. Diversification doesn’t guarantee higher returns or protect against losses, but it can help you maximize the potential of your investments at any level of risk you’re comfortable with. It’s an essential step in achieving your financial goals.
Creating a well-rounded portfolio that includes alternative investments is one of the most effective ways to diversify. This is a long-term approach that can help investors weather market volatility.
For example, a diversified alternative investment portfolio may include a variety of real estate investment trusts (REITs), exchange-traded funds (ETFs) and treasury bills. These investments can provide stable income, and they have a low correlation with stocks.
Diversification can also involve adding investments that track the performance of specific factors, like company size or style, and even global exposure. These types of investments can help to further reduce correlations with other asset classes, especially if the global economy experiences a slowdown.