Diversification is a basic concept that's critical to building a portfolio able to withstand the test of time. It is the process of spreading your money among a variety of securities to reduce exposure to any one investment or asset class. The premise behind diversification is easy to grasp: When you diversify across a range of investments, you may reduce risk by creating the potential for better performers to compensate for poor performers.
Effective diversification involves more than simply owning a jumble of different investments. It means selecting a mix of securities that may not react the same to a given set of conditions -- investments that carry a low correlation to one another. Correlation is a statistical measure of the degree to which two securities perform the same under particular market conditions. For instance, if you choose stocks of two companies that make the same product and serve the same market, chances are that they will move in tandem when conditions affecting their industry change. Owning both would be unlikely to lower risk in your portfolio. Alternatively, owning stocks of companies that operate in different segments of the economy may help improve your risk-adjusted return, although past performance is no guarantee of future results.
Diversification vs. Asset Allocation
On its most basic level, diversification can be applied to asset classes by allocating your investments among the three fundamental asset classes: stocks, bonds, and cash. Your asset allocation is the percentage of money you decide to put into each asset class based on your goals, risk tolerance, and time horizon. Technically speaking, asset allocation may potentially reduce market risk; diversification potentially reduces company-specific risk. Together, they may help reduce portfolio volatility over time. Keep in mind that neither diversification nor asset allocation guarantees against investment losses.
Both asset allocation and diversification are particularly important when a market takes an unexpected downturn. In such a shift, some investments are inevitably affected more than others, and the overall effect of a downturn on a diversified portfolio may potentially be mitigated. Consider the investor who invested 100% in financial stocks at the beginning of 2008 (the last year the stock market as a whole declined), as represented by the total returns of the S&P 500 Financials index. He would have lost approximately 55% of his investment by the end of the year. If the same investor had diversified his holdings to encompass a broad representation of all stocks by investing, for instance, in an index fund that paralleled the S&P 500 index, he would have lost only about 37% over this period. If the same investor had further diversified his portfolio by allocating 20% to cash and 30% to bonds and invested the remainder in the same S&P 500 index fund, he would have narrowed his losses to about 16%.2
Putting Concepts to Work
The first step in building a diversified portfolio is to determine your asset allocation. How you diversify your portfolio among stocks, bonds, and cash will depend upon your specific goals, your time horizon, and your risk tolerance. A financial advisor can help you determine an allocation that suits your specific needs. You'll also want to revisit your asset allocation on an annual basis, making appropriate alterations depending on your goals.
With your allocations determined, you're ready to begin choosing investments for each asset class. Here, you have two basic options. The first is to research and assemble individual securities for your stock, bond, and cash allocations. Taking this route, however, can require a significant amount of research. In addition, you would need to commit adequate time to monitor and manage the individual securities.
Alternatively, you could diversify by selecting a mix of mutual funds or exchange-traded funds. Because they hold baskets of securities, such pooled funds provide instant diversification, although the degree of diversification varies depending upon each fund's investment strategy. A fund that replicates a broad market benchmark such as the S&P 500 would provide greater diversification than a fund specializing in one sector of the economy, such as utilities or health care.
Diversifying by Investment Type or Style
Within the different asset classes, you can also diversify your holdings by investment type or style. For stocks, there are a number of different styles to choose from: growth vs. value, large-cap vs. small-cap, domestic vs. foreign, or sector/industry. These and other style groups are all represented by numerous mutual funds that may react differently to market circumstances.
For bonds, there are many different types to select from. You may choose to diversify by type (government, agency, municipal, corporate), maturity, credit quality, or specific bond features, keeping in mind that different bonds react differently to market interest rates and other factors.
However you choose to diversify your portfolio, remember that diversification works two ways. Although it can cushion the impact of a falling market, it can also dilute returns on the upside. Ultimately, you should balance your degree of diversification with your overall appetite for risk.
Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.
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2DST Systems, Inc. Bonds are represented by the total returns of the Bloomberg Barclays U.S. Aggregate Bond index. Cash is represented by the Bloomberg Barclays U.S. Treasury Bill 1-3 Month index. Individuals cannot invest directly in an index. Past performance is no guarantee of future results.
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