What Is Diversification In Investing & Why Is It Important?

Ashley JacksonOctober 1, 2021

Investing can be daunting. Without a doubt, the wrong investments can lead to financial ruin. However, you’ll reap enormous financial rewards if you make the correct investments. Unfortunately, 22% of U.S citizens have less than $5,000 in retirement savings. What’s more, 15% of Americans have zero retirement savings at all. 

The average U.S citizen starts investing for their retirement at 27. Therefore, that’s possibly forty years of investment potential. If you make the best investments from a young age, you can genuinely start building financial freedom. One of the most excellent ways to mitigate risk and balance volatility is through diversification in investing. 

What Is Diversification?

Diversification is the act of spreading investment dollars through a range of assets. In turn, you’ll reduce investment risk. Many people in the financial services sector call this asset allocation, meaning how much you invest in various asset classes or groups of similar investments. For example, let’s suggest you invest in different types of produce. How about bananas, grapes, broccoli, and tomatoes? Your general asset class would be ‘fruits’ and ‘vegetables.’ 

In short, diversification is the simplest and safest way to increase your returns without making significant risks. However, if you put all your eggs in one basket — which many people sadly do — you’ll run the risk of losing your investment if there’s extreme market volatility. 

During the Global Financial Crisis, far too many investors had their money in one asset class. For many investors, that was real estate investments. We all know that happened there. It should be a lesson to people now that are saving for retirement. You never know when the next economic crisis is going to hit. 

Diversification By Asset Class

There are three primary asset classes in an investment portfolio. These are bonds, cash, and stocks. 

• Stocks – Investors often refer to stocks as equities. In short, stocks enable investors to own a piece of a company. But, as many investors soon realize, you have to know which companies have the brightest future. Stocks offer the highest long-term gains, but they’re volatile in a cooling economy. 
• Bonds – Investors often refer to bonds as equities. Bonds pay interest to investors who lend money to a company or a government. Bonds offer moderate returns and are weaker during a booming economy. That said, bonds generally have an inverted relationship with stocks. 
• Cash – Cash is simply the money in your savings account or hidden in your piggy bank at home. Cash is very low on returns and risk. However, many experts argue that leaving your cash outside an asset is riskier because interest rates with banks are generally weak. 

There are other asset classes, such as commodities, real estate, and alternative assets. You may have also seen the boom in cryptocurrency recently, although many experts suggest that it’s too volatile to be classed as an asset. 

Diversification Within Asset Classes

Stocks

• Industry or sector – It’s an excellent idea to diversify your stocks into various sectors and industries. Firstly, you’ll need to understand which industries have a bright future and which industries are going to struggle. 
• The size or market capitalization – Market capitalization is a fancy way of saying, “how big is this company?” The financial sector defines a company’s market cap by the value of the company’s tradable stock. Larger companies are the most popular because they can withstand an economic downtown. However, they often lack the growth of small to medium-sized companies. 
• Style – Couple growth and value-oriented stocks are often expensive, but investors believe the price is worth it based on future growth forecasts. Value stocks are companies that the market has underpriced. As a result, they are often superb investments. 

Bonds

• Maturity – These bonds are a mixture of short, medium, and long-term bonds. Longer-term bonds receive higher returns because they tend to have greater interest rates.
• Credit quality – You should combine bonds with varied credit risks. That’s because bonds offer different levels of creditworthiness or safety. In turn, that affects the bond’s level of return. 
• The type of issuer – You should integrate bonds from various issuers, such as treasuries, municipal bonds, and corporates. 

For Both Stocks and Bonds

• Geography – The geography of your stocks and bonds is critical. You should incorporate stocks and bonds from all over the world. You can find some excellent markets across the globe, including Australia, Singapore, Japan, and the U.K.
• Active vs. passive – You should allocate a mixture of passively managed funds and actively managed funds. You can do this through mutual funds, index funds, and ETFs.

Diversification Beyond Asset Classes 

You can invest beyond the traditional asset classes, such as investment accounts. However, investment accounts don’t have guaranteed returns because of market fluctuation. In contrast, pensions, annuities, and insurance options can provide a robust and safe return on investment. 

Many investors will split their risk by investing through these non-traditional assets too. Another example is a diversified REIT portfolio. Many investors choose this asset class because it consists of safe building and apartment investments. 

Why Is Diversification so Essential?

You spend your whole life trying to build financial freedom so that you can enjoy your retirement. That’s the best thing to do. However, if you have all of your investments in one basket — you run the risk of losing your investment if anything unforeseen occurs. 

Investors often refer to diversification as a ‘free lunch’ because it reduces overall risk while offering some outstanding returns. Don’t let one asset class that starts to underperform harm your entire investment portfolio. 

Does Diversification Work?

Diversification is an excellent way of reducing risk. But it’s impossible to remove all risks when you’re investing. There are two main risks when you invest:

• Market risk – Market risk comes with owning any asset, including cash. You simply can’t escape the risks of the market. Of course, you can watch market trends and predict potential dips and crashes. Nonetheless, the risk is always there. 
• Asset specific risks – Asset specific risks come from the company or investment themselves. Again, it’s impossible to avoid this risk. You can pick the best companies and the safest assets, but the risk is always there.

If you decide to diversify your investments, you’ll reduce the risk overall because you’re not relying on one asset class. For example, what if you invest all your money in oil shares and there’s an oil crash like in recent times. You’ve probably lost your entire investment. That’s a nightmare we want you to avoid by diversifying. 

How to Build a Diversified Investment Portfolio

You might be wondering, is it hard to build a diversified investment portfolio? The answer is no. You can purchase most securities in a collection, such as index funds, EFTs, or a mutual fund. You can also purchase securities individually. 

It’s up to you, but the process is easy if you use a fund manager. The main benefit of hiring a fund manager is relying on expert advice. That’s very important if you’re struggling to find the time to research companies. 

Diversification Can Be Simple or Complex 

If you’re looking for simple diversification, you can simply invest through an EFT or mutual fund on the S&P 500 index. These are 500 of America’s leading companies. You can gain immediate diversification when you invest in the S&P 500 because of the sheer number of companies, industries, and some of these companies involve themselves in substantial overseas markets. 

Alternatively, if you want a broader investment portfolio, you should consider adding bonds to your portfolio too. Most large companies will offer bond funds and some index funds for investors. Plus, they’re often readily available on 401(k) plans and individual retirement accounts. Some investors choose a PSF diversified bond portfolio because it can bring excellent long-term results. 

Furthermore, you can opt for a target-date fund. These funds will manage your asset collection and diversification. You only need to choose your retirement year, and your fund manager will do the rest of the work. It’s that easy. Some people choose to invest in CPSE exchange-traded fund growth or money control index funds. Another option is using a tax loss harvesting robo advisor to offset any capital gains tax on your investment through non-sheltered accounts that follow IRS guidelines. The options are unlimited. 

Final Thoughts

Don’t get caught out with only one asset. It happens all the time. When you go through the process of diversifying your assets, you’ll reduce risk significantly. But not only that, you can reap immense financial rewards.

The saying never put your eggs in one basket is absolutely critical when talking about investing.