You’ve probably had someone tell you not to put all of your eggs in one basket, and this is exactly what it means to diversify your portfolio. Consider this: if you invested all of your money in one stock and the stock price fell, you would lose your money. If you had a diversified portfolio that included many different investments, you may have gained money on other investments, even if the price of that one stock fell.
A diversified portfolio reduces an investor’s risk, as losses in one investment may be offset by gains in another. “Investment professionals will look at the correlation between assets -- that is, how closely the prices of two assets have moved together in the past. What is desirable is to hold assets in a portfolio that aren’t highly correlated to each other, and hopefully, when one investment is going down another investment is moving up,” said Robert Johnson, CFA and president of the American College of Financial Services.
Beyond diversifying among the types of assets you own, you also need to diversify within the types of assets. For stocks, it’s important to have stocks in your portfolio from a large variety of companies, including companies in different sectors or industries, such as consumer staples or materials; from companies of different sizes, such as large-cap or small-cap stocks; from companies in different countries and from companies that either have growth potential or good dividend yields. Similarly, you should have a variety of bonds in your portfolio, including Treasury bonds, municipal bonds, corporate bonds, bonds with different maturities, foreign bonds and high-yield bonds.
You may be thinking it would be impossible to buy that many securities. This isn’t the case. “You can achieve diversification by owning very few assets and can be highly concentrated (undiversified) by owning many assets. The best example of diversification with one investment is to own a diversified index mutual fund -- for instance, one that tracks the S&P 500. By investing in that security you own a piece of 500 different companies from many different industries. On the other hand, one could purchase ExxonMobil, BP, Chevron, ConocoPhillips and Occidental Petroleum -- five different companies -- and be highly concentrated in the oil sector,” said Johnson.
For these reasons, mutual funds and exchange-traded funds (ETFs) are very popular among individual investors. Funds allow you to own a small piece of tens or hundreds of different securities, making it easier to diversify your portfolio. Mutual funds and ETFs come with a variety of fees charged by the fund company and transaction commissions charged by brokerages (some brokerages may offer no-transaction-fee mutual funds or commission-free ETFs). A popular type of fund is index mutual funds and ETFs, which cover the market broadly or a specific index like the Standard & Poor’s 500 (S&P 500). Index funds typically have some of the lowest fees of any funds and many are well diversified because they follow broad market indexes.
An investor may choose to purchase a broad domestic stock index fund, an international stock index fund and a bond index fund to diversify her portfolio. She might buy an index fund that tracks the S&P 500 for her domestic fund, an index fund that includes stocks from all countries (except the U.S.) for her international fund and a fund that tracks the Barclays Capital U.S. Aggregate Bond Index for her bond fund. Even among index funds, there are many options as there are many different market indexes. If you’re considering investing in any type of fund, make sure to read the fund’s prospectus to understand the investment objectives, the components of the fund, policies and fees.
Finally, diversification can be spread out across any accounts you own. You may designate one brokerage or retirement account for bonds and another for stocks. Your total portfolio would still be diversified, but each account would only hold one type of security. Ultimately, the way you achieve a diversified portfolio is up to you, but it’s important that you are diversified correctly.