Diversification is the practice of owning a wide variety of investment types in order to reduce risk.
Investors sometimes find the idea of diversification daunting, but it’s nothing more than not putting all of your eggs into one basket.
For instance, owning 1,000 stocks through an index fund provides more diversification than owning 100 stocks in an active mutual fund and far more than owning 10 stocks directly. If those investments are different from each other, that increases the level of diversification.
Furthering the stock example, diversification means owning both large-cap stocks and small-cap stocks and both foreign and U.S. stocks. Larger portfolios might drill down into mid-caps, emerging market stocks, dividend stocks and so on.
From there, diversification might continue into owning additional investment asset classes, such as bonds, real estate, commodities and cash.
Investors come and go from the different asset classes depending upon their collective perception of the economy, politics, corporate earnings and other factors. Nevertheless, they rarely abandon an asset class and, often, market prices revert to the long-term average, or mean, for that asset class.
Diversification thus can provide much of the returns of each asset class while not amplifying the risk that comes from putting all of your money into any one investment type.
Diversification is a proven portfolio strategy that far too many people ignore at their own risk.
Often, investors load up on a single stock because they see it touted on television or on the Internet. Others build up a retirement plan by taking company stock from their employer and never selling. Pretty soon, it’s most or all of their money in one stock.
Loyalty to a company is fine, but the price of that loyalty to your retirement can be high. Just ask anyone who held Enron or General Motors stock when those companies went under!
Sad as those stories are, you can diversify automatically by using a large-cap mutual fund to own stocks instead of picking them yourself. Most mutual funds own dozens or hundreds of positions as a matter of investment policy.
An index fund, meanwhile, is by definition diversified since it holds all of the stocks in an index, such as the 500 stocks in the S&P 500, or the thousands of stocks in a world stock or total market fund.
From there, it’s good practice to add diversification across multiple asset classes, such as bonds, real estate and commodities. You will find instant diversification by owning index fund products that track the benchmarks for each distinct asset grouping.
Over time, normal market movements will cause your portfolio to become overweighted in some of these initial asset class choices. Rebalancing — selling investments that have gone higher and buying more of those that have moved lower — is a simple way to return to your target portfolio.