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What Is Diversification? And How Do I Do It?

March 16, 2021

If you've read almost any book, article, or blog on investing, you've seen the word "diversification." But experience has taught me that most investors - even educated ones - still don't understand what diversification is, how it works, or why it's important. In my continuing crusade to offer plain English explanations of sometimes complex topics, I'm taking on this vital and often misunderstood concept.

Strap in. This is going to be fun! (I promise.)

What Is Diversification?

Diversification is all about dealing with risk. According to Investopedia, diversification is "a risk management strategy that mixes a wide variety of investments within a portfolio." The definition can get more technical and complex than that, but allow me to go the other way and speak in plain English: it means not putting all your eggs in one basket.

Being diversified means owning a mix of different asset types such as stocks, bonds, cash, real estate, or alternative investments.

It also means owning a variety of securities within each asset type. Further, diversification can also apply to having different approaches, products, or strategies in place within your portfolio of investments. Let's examine each of these types of diversification in turn.

Diversity of Asset Class

The major assets classes are stocks[1], bonds[2], and cash[3]. Some investors also include real estate[4] and alternative investments[5] in their asset class mix.

Most investors should own some of each of the three major asset classes.

How much of each depends on the investor's ability to tolerate risk. The proportion of stocks to bonds and stocks to cash will strongly influence what return an investor can expect to earn on average each year. It will also influence how much the value of the portfolio will move up or down when the stock market moves up or down. More bonds and cash mean less movement with the stock market.

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Diversity Within Asset Class

It's not enough to just own a mix of different asset classes. An investor should diversify within each asset class. The big exception here is cash. You can't really diversify cash (nor do you need to).

But the principle does apply to stocks, bonds, real estate, and alternative investments. You could seek out, research, and purchase individual stocks and bonds - but that's rather time-consuming and beyond the scope of what most individual investors feel comfortable with.

So, what's an investor to do?

Many investors (especially those just starting out) choose to own pooled investments like Mutual Funds or Exchange Traded Funds.

Both products allow an investor to buy a slice of a larger pool of assets.

For example, let's say an investor has $5,000 they wish to invest in stocks and another $3,000 to invest in bonds. It would be a stretch to buy more than 10 different stocks and even one bond with that amount of money.

What if instead this investor bought $5,000 worth of a Large Cap Stock Mutual Fund and $3,000 of an Intermediate Term Bond Fund? The stock fund may own as many as 90 different stocks, and the bond fund may own as many as 100 different bonds that have been researched, analyzed, and chosen for their potential to fulfill the mutual fund's stated goals.

And just like that, our investor is well diversified across two asset classes.

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Diversity of Approach

There are many ways to approach investing. Some investors are strategic, picking a long-term asset allocation and sticking with it for many years. Some are tactical, making changes to asset allocation regularly.

Some investors like active management, where the goal is to outperform a relevant benchmark. Some prefer passive management, where the goal is to track the performance of an index or market sector. Some investors prefer pooled investments only, and others might enjoy owning only individual securities.

Each of these approaches will enjoy varying levels of success depending on the investing environment.

For example, in some years active managers far outpace their benchmarks, but in other years they may struggle to keep pace and may even lag behind.

While it's not necessary, it may be wise to have more than one investing approach represented in your portfolio.

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Why Bother With Diversification?

Building a diversified portfolio takes a good deal of work. You must decide how you'll divvy up your investments between stocks, bonds, and cash. You must make a call on including or excluding real estate and alternative investments. Then you must pick individual securities or a handful of pooled investments. And maybe you even put in place more than one approach. But why bother?

We all know the sage advice to not put all your eggs in one basket. Failing to divide your proverbial eggs into multiple baskets puts you at much greater risk if anything should happen to your single basket.

Put another way: if you put all your resources into a single asset and something happens to that asset, you've risked too much and lost.

Whereas, if you have many different assets and something happens to one of them, it will still hurt - but not that much.

Diversification is the first step in dealing with the inherent risk that comes with investing.

Fortunately for you, building a well-diversified portfolio has never been easier.

But if the thought of all this due diligence bores you to death or makes you feel intimidated, hiring a Financial Advisor may be the right next step for you. A good Financial Advisor will spend her time figuring out how much risk you can tolerate, how much risk you actually need to take, which type of investment vehicle will best serve your needs, and what approach or mix of approaches may suit you best. And because she's a pro, she'll likely do it quicker and with less stress than you might if you tried to DIY all of this, while also teaching you what you need to know. Sounds like a pretty good deal to me.

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Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. This and other information can be found in the prospectus or summary prospectus. A prospectus or summary prospectus may be obtained from your financial professional. Please read the prospectus or summary prospectus carefully before investing.

Past performance is not indicative of future results and diversification does not ensure a profit or protect against loss. All investments carry some level of risk, including loss of principal. An investment cannot be made directly in an index.

Fixed income is generally considered to be a more conservative investment than stocks, but bonds and other fixed income investments still carry a variety of risk such as interest rate risk, regulatory risk, credit risk, inflation risk, call risk, default risk, political risk, tax policy risk and liquidity risk.

[1] Sometimes referred to as equities.
[2] Sometimes referred to as fixed income.
[3] May include "cash equivalents" like money market funds.
[4] Either direct ownership of revenue-producing properties, or through Real Estate Investment Trusts.
[5] Any asset that does not fit neatly into the stock, bond, cash or real estate category.