What Does Diversification Mean for Investors?

You’ve probably heard that you shouldn’t “put all your eggs in one basket.”

In investing, the practice of having multiple baskets is known as diversification. It helps you to minimize your risk — if one basket drops and breaks most of the eggs inside, you’ll still have other eggs to rely on. 

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What Is Diversification?

In simplest terms, diversification means that you purchase many different types of investments. These could be different asset classes, like stocks and bonds, or different sectors, like investing in tech and transportation.

That way, if one type of investment or one economic sector performs poorly, you still have other investments in other asset classes or sectors to balance out your portfolio.

For example, maybe you invest in a variety of stocks, bonds, mutual funds, real estate, etc., instead of just one company’s stock — so if that company has a bad quarter, you don’t risk a decline in your entire portfolio.

READ MORE: How To Build Your Core Portfolio

Benefits of Diversification

Diversification can help minimize your losses. It also gives you the flexibility to withstand temporary market fluctuations. 

The stock market goes up and down, but by diversifying, it’s likely that some of your investments will be up, even if others are not performing well.

It also gives you more opportunity. When you diversify, you can invest in a wide variety of assets and markets. You can benefit from foreign markets and different sectors.

How To Diversify Your Portfolio 

To diversify, you’ll need to purchase investments in several different asset classes. Here are some examples of assets:

• Stocks: Shares of a company
• Bonds: Secured loans you give to the government or corporations that earn interest
• Real estate: Includes personal real estate, commercial real estate, rentals, and real estate investment trusts (REITs)
• Commodities: Can include gold, silver, natural gas, food crops, and even livestock
• Cash: Actual cash, money market funds, Treasury bills, and high-yield savings
• Funds: Collections of stocks inside one package, such as a mutual fund or exchange-traded fund (ETF) — making them inherently diversified.

You can diversify your portfolio even more within each asset class by spreading out your investment to different sectors and industries. For example, you might purchase stocks or mutual funds in the technology sector or healthcare.

Many investors choose international funds so their investments are diversified geographically as well. Not all economies are the same, and some perform better than others depending on global factors.

Finally, you can diversify by market capitalization, which means the size of a company. For example, you can invest in some small companies as well as larger companies.

READ MORE: How to Manage Your Own Investment Portfolio

How Is Asset Allocation Different from Diversification?

Your assets are the things in your life that have monetary value, like your house, car, savings, and investments. Asset allocation is when you decide how to split up your money, or allocate it, to different investments. 

For example, you might invest in asset classes like stocks, mutual funds, and real estate.

Diversification is when you select different investments within each asset class. So, if one of your asset classes is stocks, diversifying means you’d purchase several different types of stocks.

To put it another way, the food in your refrigerator is full of asset classes. You have fruits, vegetables, and dairy items. Those categories are your asset allocation, but within each category, you likely diversify. You probably have more than one type of fruit, more than one type of vegetable, and so on.

When Is There No Benefit to Diversification?

There are times, like during the 2009 recession and the pandemic, when there is wide-spread disruption in the market. During those times, it’s possible that many different asset classes will be down all at once.

That doesn’t necessarily mean you have to change your investment strategy or sell your holdings. However, it does mean that you might have to be patient until the market recovers.

Additionally, if you diversify too much and have too many different types of investments and accounts, it can be challenging to manage your money. Ideally, you want a well-diversified portfolio that’s also straightforward to manage.

READ MORE: Understanding Value-at-Risk and Your Loss Potential

TL;DR: Diversified Investments

No one can predict what the market will do, but over time, you can reduce your risk by diversifying your investments. When you diversify, your investments are spread across many different asset classes and potentially across different global markets, too.

The goal is to protect your money over the long term. If one of your investments performs poorly, being diversified means you’re more likely to withstand the downturns.

For more tips on managing your investments, check out these episodes of the Erika Taught Me podcast:

• Investing in the Stock Market Explained: A Guide For Beginners
• 10 Steps Towards Financial Wholeness
• The Missing Piece in 99% of Financial Advice

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