Investing in the stock market can be like a roller coaster ride, with stomach-churning ups and downs. One way to smooth the ride is to employ diversification strategies.
These strategies include more than simply not “putting all your eggs in one basket.”
What is diversification?
Diversification in investing refers to spreading your investments across various asset classes and sectors to reduce risk and potentially increase returns. By diversifying your portfolio, you can reduce the impact of any single investment on your overall portfolio performance and increase the likelihood of achieving long-term financial goals.
Diversification in investing is important because it helps mitigate risks associated with investing in a single asset or market. Diversification can help protect your investments from market volatility and other unpredictable events that can cause significant losses. However, it is not a guarantee against loss in the value of your portfolio.
The rationale supporting diversification is that a portfolio consisting of diverse investments will, on average, yield higher returns and pose a lower risk than any individual investment within the portfolio.
Diversification Across Asset Classes
Investing in different asset classes is a fundamental way to diversify your investment portfolio. These asset classes typically include stocks, bonds, cash, real estate, and commodities.
The premise of investing in different asset classes is that, in theory, their returns are
not perfectly correlated. For example, when the stock market is experiencing a downturn, bonds might hold steady or even increase in value. This dynamic was seen during the 2008 financial crisis, when the S&P 500 index fell by 37%, while the Bloomberg U.S. Aggregate Bond Index rose by 5.24%.
However, there are exceptions when diversification doesn’t work. In 2022, stocks (as measured by the S&P 500 index) lost 18.6%. Bonds, as measured by the Vanguard Total Bond Index, lost 13.7%, which was the worst annual bond return in the past 97 years.
Diversification Within Asset Classes
Once you’ve allocated your resources across different asset classes, there’s still more work to do on the diversification front. Within each asset class, you can diversify further.
With your stock portfolio, diversification involves investing in companies of various sizes, known as small-cap, mid-cap, and large-cap companies, and within different sectors like technology, finance, and health, and in other geographical locations, like the U.S., Europe, Asia, and emerging markets.
Only investing in one sector, like large technology companies, exposes you to sector-specific risk. If technology stocks take a hit, so does your entire portfolio. By holding a mixture of technology, healthcare, finance, and consumer goods stocks, the impact of a downturn in any one sector will (at least theoretically) be mitigated by your holdings in other sectors.
An easy way to diversify
For individual investors, achieving diversification can seem daunting, given the many options and the costs involved. This is where mutual funds and Exchange Traded Funds (ETFs) come in. These funds pool resources from many investors to buy various stocks, bonds, or other assets.
For instance, consider an S&P 500 index fund. This fund offers exposure to 500 of the largest U.S. companies spanning various sectors. You gain instant diversification within the stock asset class without needing to research and invest in each company individually.
You can achieve broader diversification by investing in Target Date Funds and mutual funds with pre-determined asset allocations.
Target date funds are investment funds that automatically adjust their allocation to stocks and bonds over time. As the target date (typically the date when you anticipate retiring) approaches, the investment mix will gradually shift from higher-risk investments (stocks) to lower-risk investments (bonds).
Diversification through dollar-cost averaging
Diversification isn’t just about where or how you invest but also when you invest. Dollar-cost averaging involves regularly investing a fixed amount of money, regardless of market conditions. This approach can lower your investment’s average cost per share and mitigate the risk of investing a large amount at a single point, essentially diversifying your investments across different market periods.
Diversification is a long-term strategy, not a get-rich-quick scheme. It’s about steadying your investment ship in a sea that can sometimes be calm and, at other times, choppy. It can help mitigate extreme outcomes and provide a smoother investment journey.