Diversifying Your Portfolio Reduces Your Risk in Investing. Here's Why That's So Important
investing is one of the best ways to build wealth and reach your long-term financial goals. But what should you invest in? While there’s no one right answer for everyone, there is one principle that can help guide your investing decisions: diversification.
“No matter what your goal is, diversification is a key to investing,” says Corbin Blackwell, a senior financial planner with Betterment.
As with many things in the world of finance, diversification seems complicated at first. But we’ve spoken with two investing experts to help break down what exactly diversification means, how diversified your portfolio should be, and how to start diversifying your portfolio right now, even with a small amount of money.
What Does it Mean to Diversify Your Portfolio?
When you diversify your portfolio, you incorporate a variety of different asset types into your portfolio. Diversification can help reduce your portfolio’s risk so that one asset or asset class’s performance doesn’t affect your entire portfolio.
There are two ways to diversify your portfolio: across asset classes and within asset classes. When you diversify across asset classes, you spread your investments across multiple types of assets. For example, rather than investing in only stocks, you might also invest in bonds, real estate, and more.
When you diversify within an asset class, you spread your investments across many investments within a certain type of asset. For example, rather than buying stock in a single company, you would buy stock from many companies of many different sizes and sectors.
Why Is It Important to Diversify
The primary goal of diversification is to spread out your risk so that the performance of one investment doesn’t necessarily correlate to the performance of your entire portfolio.
“Remember the old saying, ‘you don’t want to put all your eggs in one basket?’” says Delyanne Barros, an investing expert and the founder of Delyanne the Money Coach. “Now imagine that basket is one stock. Putting all your money on one company or just a handful of companies can be extremely risky when it comes to investing. If one of those companies goes bankrupt or their performance suffers, your investment will suffer too.”
You don’t want the success of your investment portfolio to hinge on a single company, so you can reduce your risk by spreading your investments across many different companies, or even other asset classes.
Additionally, different asset classes — and even different assets within the same asset classes — behave differently depending on the market conditions. Having a variety of different investments in your portfolio means that if a part of your portfolio is down, the entire thing isn’t necessarily down.
Finally, diversification can help you combine assets of different risk levels in your portfolio. For example, stocks have historically produced higher returns than bonds or cash, but they also come with more risk. On the other hand, while bonds don’t produce the same high returns that stocks historically have, they can hedge some of your portfolio’s risk for those years when the stock market is down.
How Diversified Should Your Portfolio Be?
There’s no magic formula that can tell you exactly how diversified your portfolio should be. However, a basic rule of thumb is to include investments in your portfolio whose returns aren’t correlated with one another. That way, if a market event affects a part of your portfolio, it either doesn’t affect the entire thing, or it has an opposite effect on another part of your portfolio.
As we mentioned earlier, you can diversify across or within asset classes. First, include assets other than stocks in your portfolio. Bonds are a popular addition to many investment portfolios, but you could also include real estate or other alternative investments. Second, be sure your stock investments are diversified. You can achieve this in a few different ways:
- Invest in companies across different stock market sectors
- Invest in companies of different sizes (large-cap, mid-cap, and small-cap)
- Invest in both domestic and international stocks
One mistake you could inadvertently make as an investor is to put your money in multiple funds that hold basically the same assets.
“A common misconception is that people think they have a bunch of funds, and so they’re diversified,” Blackwell said. “Having more positions in your portfolio doesn’t mean you’re more diversified. Good diversification is having different areas of the market that don’t behave the same.”
For example, you might invest in one S&P 500 index fund and one total stock market index fund, thinking that you’re gaining exposure to a wide variety of investments. But about 75% of the total U.S equities market is made up of stocks that are already in the S&P 500, according to Moringstar. So instead of further diversifying your portfolio, you’ve invested in most of the same companies twice.
“You want assets that behave differently from one another, whether inversely or completely independent of each other,” Blackwell said. “Just having a lot of mutual funds or stocks or ETFs doesn’t mean you’re well-diversified, depending on what’s in them.”
Remember that the appropriate level of diversification for you also depends on your financial goals, your time horizon, and your risk tolerance. As these things change over time, so should your asset allocation. Generally, the closer you are to retirement, the smaller percentage of your retirement fund should be kept in stocks.
Changes in market conditions may also affect your level of diversification without you realizing it. If one investment or asset class does particularly well over a period of time, it may come to represent a larger part of your investment portfolio in terms of monetary value, even if the number of shares you own stays the same. If this happens, you may want to buy or sell certain assets to restore your portfolio back to its original asset allocation. This is known as rebalancing.
How to Start Diversifying Today
One of the simplest ways to create a diversified investment portfolio is to invest in pooled investments. A pooled investment is a single investment fund that holds hundreds, or even thousands, of individual investments.
Exchange-traded funds and index funds are popular types of pooled investment funds, and you can use them to gain exposure to a wide range of assets with a single investment. Some of the most popular ETFs and index funds cover the S&P 500, the NASDAQ, or even the total stock market.
Another tool that can help you diversify your portfolio is a robo-advisor. Investors can use robo-advisors to build a diversified portfolio without having to research and select their own investments. When you sign up for a robo-advisor, you share information about your financial goals and the robo-advisor builds a diversified portfolio on your behalf, automatically rebalancing it over time.
PRO TIP: You can easily diversify your portfolio using index funds and robo-advisors, even with a small amount of money. Just make sure you’re choosing a diverse selection of funds that are appropriate for your financial goal and time horizon.
One final tool that makes it easier to diversify your portfolio is fractional shares, which are simply a portion of a single share of stock.
“Fractional shares allow you to purchase however much you can afford of a single share and still get the diversified exposure you want in your portfolio,” Barros said. “Investors can literally start investing with a dollar. Brokers like Fidelity and Charles Schwab are some examples that offer fractional shares.”
Tesla’s stock, for example, was trading at more than $1,000 per share in the second week of January 2022, making it unaffordable for many investors. But with a broker that offers fractional shares, you could purchase just part of a share to make it fit within your budget.
Do You Need a Minimum Amount Invested?
The good news is that there’s no minimum amount of money necessary to create a diversified portfolio. In the case of an ETF, the price needed to get started is simply the cost of one share of the fund. In some cases, the price of an ETF share can amount to hundreds of dollars. But just as you can buy fractional shares of individual stocks, you can also buy fractional shares of ETFs with certain brokers.
Some brokers — Vanguard is one well-known example — require a minimum investment on their index funds. But many other brokers allow you to invest in index funds with no minimum investment.
If you choose to invest with a robo-advisor, you’ll also be able to get started with just a small amount of money. It depends on the company, but some robo-advisors require a minimum investment of just $10.
It’s important to note that while the actual dollar amount required to start investing may be low, there are a few financial milestones you may want to reach before you start investing.
First, ensure that you’re able to meet all of your financial obligations each month. If you’re having trouble paying the bills, you may want to wait until you’re in a more stable place financially before you open a brokerage account. Similarly, consider building your emergency fund first. While the recommended amount for an emergency fund varies, most experts advise that you have at least three to six months of living expenses in the bank.
Finally, if you have high-interest debt such as credit cards or payday loans, it’s wise to pay those off before you put your disposable income toward investing. The interest rates on these types of debt may be higher than your potential investment earnings, meaning prioritizing high-interest debt actually results in a higher return.
Once you’ve checked those tasks off your financial to-do list, you can feel confident putting some money into a brokerage account each month. Even if you have just a small amount to start with, your investment can still go a long way, especially if it has many years to grow.
To view the full article: https://time.com/nextadvisor/investing/why-diversifying-portfolio-is-important/
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs.
All company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF's net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors.