How To Diversify Your Investment Portfolio

If you’re looking to expand your investment mix, you may be surprised to discover just how simple portfolio diversification can often be. Diversification, or the practice of making sure your investment portfolio contains a mix of investments, is helpful to lower your risk in the event one or some of your investments don’t perform as well as you hope. While it may sound complicated, in fact, all it takes is some up-front planning and research to diversify your portfolio and reduce your risk.

Discovering how to diversify your investments is typically one of the first lessons that most investors learn, and for good reason. But what is portfolio diversification and why is it important to diversify your investments? We’re glad you asked: Let’s take a closer look at how to diversify your portfolio, why doing so can help you safeguard against market risk, and how to get in the habit of diversifying as you explore different opportunities.

What Is Portfolio Diversification?

Portfolio diversification describes a common investment practice where investors actively spread their investment portfolio out across different asset classes and securities. Common asset classes include stocks, bonds, and cash equivalents, where common types of securities include debt securities, equity securities, derivative and hybrid. In effect, engaging in this practice spreads your risk and limits your exposure to any one specific asset type, to help protect your portfolio in the event of an unexpected downturn, like a recession.

Learning how to diversify portfolio holdings can also help you maximize your return on investment and reduce the overall volatility of your portfolio over time.

This practice allows you to hedge against risk and keep potential losses to a minimum while also staying flexible enough to adapt to changes in the market. When you’re well-diversified financially, if one area of your investment portfolio underperforms, you may be able to balance it out with gains in another area.

A well-rounded investment portfolio often includes a mix of stocks, bonds, commodities, cash, cash equivalents, mutual funds and ETFs. Make a point to practice diversification, and you’ll help offset the risk of market volatility by engaging in the practice of asset allocation, which essentially looks at how much of your portfolio you’ve dedicated to elected certain asset classes. Asset classes include the categories described above, like bonds, stocks and cash, among others.

Why Is It Important To Diversify Your Investments?

Not only does holding a variety of different assets in your investment portfolio decrease the chance of one particular asset hurting your overall portfolio, but it also increases the odds that you’ll experience upswings in different areas of the market when other asset types go up. The more diversified you are, the better you’ll be able to withstand dips in the market and more opportunities that you’ll have to enjoy potential gains. Bearing this in mind, as well as the fact that all asset classes are subject to downswings and upswings in interest over time, portfolio diversification is a smart move. It can help investors feel less stressed about the movement of their assets in the short-term, knowing that things should even out (and hopefully grow) over time.

Portfolio Diversification Example

For example, Taylor and Zoe, millennial and Gen Z siblings looking to grow their net worth, might elect to invest the largest portion of their investment portfolio in assets with high potential gain such as stocks, mutual funds, and real estate (60% of their overall portfolio). They then elect to keep 40% of their investments in cash and bonds in case the market dips and they suddenly need access to those funds, known as liquidity.

In another scenario, Bob, a baby boomer who is closer to retirement, might opt for the reverse scenario in hopes of achieving greater stability. Since he’s closer to retirement, he’ll need access to his funds sooner, with less time to recover in the event of a market downturn. In this circumstance, he might keep 60% of his portfolio in cash and bonds (often seen as a more stable and less-risky than stocks or mutual funds) and 40% of his savings into stocks and real estate, noting that he has less time and is more risk-averse as he approaches retirement.

Under both circumstances, all individuals spread their risk across multiple asset classes by practicing diversification and left themselves a financial cushion to fall back on in case the market temporarily doesn’t go their way.

6 Ways To Diversity Your Portfolio

There are many ways to diversify your portfolio, and many types of assets you can invest in no matter how much money you have to start. As you think about diversifying, you’ll want to continue adding to your portfolio of investments over time, keeping an eye on the marketplace and steadily investing in different asset types. Below are just some of many ways that investors can begin diversifying their investments.

Keep Your Investments Diverse  

One strategy is to invest in a handful of asset types that you know and trust. For some individuals, this may include stocks, bonds, commodities, mutual funds, exchange-traded funds (ETFs), or real estate investment trusts (REITs). For others, assets may take the form of residential real estate holdings, virtual real estate investments, or even cryptocurrency and non-fungible tokens (NFTs). As you plot out an investment strategy, you may also want to consult a qualified financial advisor. It’s also a good idea to research and understand your assets so you can manage your own portfolio if you choose, and not diversify so widely that you can’t feel like you can keep up with monitoring or rebalancing your portfolio.

Continue Adding To Your Portfolio

Adding to your investment portfolio over time is important as you’ll have the ability to purchase more assets when prices dip or as other assets grow. Investing regularly can also help you reduce your overall risk by investing your money over a longer period of time. One option to consider here is the practice of dollar-cost averaging. It’s a common investment strategy in which investors deal with the uncertainty of market movements by regularly investing the same sum of money at regular time intervals (say every 3 – 6 months) across a similar variety of different assets (for example, stocks and bonds) regardless of market price. That’s because doing so can help you bring down the average costs of your investments over time.

Keep An Eye On The Market

It may easy to not think much about your investments after you’ve purchased them, but in fact, it’s crucial for investors to stay on top of the stock market and keep a close eye on how their investments are impacted. The more familiar you are with how the market moves, the more prepared you’ll be when it’s time to sell or cut your losses. That said, savvy investors take a long-term approach to portfolio management, and don’t offer knee-jerk reactions in response to unexpected market movements, knowing that historically, the dips and peaks often even out over time. Rather, they buy and sell strategically, keeping an eye out for opportunities to purchase low and sell high.

Divide Your Money Between Stocks And Bonds

Making a point to divide your investments between stocks and bonds is a smart way to minimize your risk exposure. When plotting a diversification strategy, think about what your appetite for risk is, how soon you might need access to capital, and how long you might be able to wait to recover any losses in the event of a market downturn. At the same time, remember: No risk, no reward, making it important to not be overly conservative when it comes to your investments either.

Assess Possible Risk Before Making Investments

Before you buy or sell an investment, it’s worth your time to get a sense of a stock’s rating and its relative odds of success. Investors should also do ample research to assess the viability, stability, and general potential of any investment (and investment market) they’re considering. Age and personal situation should be also contributing factor to figure out where to invest. For example, as alluded above, a younger person might have a higher risk tolerance than someone who is closer to retirement age and seeking greater stability.

Follow An Investment Plan

Investment plans can help investors get a clearer understanding of how money might best be deployed across their financial portfolio. For example, a buy-hold strategy is when an investor maintains an investment portfolio and keeps it mostly stable throughout their life. This type of strategy is recommended for someone who wants to let their investments grow over time. However, many investors also find success by opting to do more short-term buying and selling of assets as well. The best plan for you will depend on your risk tolerance, available capital, and other factors. Consult a financial advisor to discuss your unique situation.

The Bottom Line

If you’re looking to diversify your portfolio, the good news is that you’re already thinking along the right lines to build a roadmap to financial success. Thankfully, from stocks to bonds, EFTs, REITs, and mutual funds, there are many different asset types to invest in and reduce your risk while leveraging your potential to increase gains. Looking to find savings to invest or get your full financial picture? Get started by creating an account with Rocket Money^SM today