What is portfolio diversification?

Portfolio diversification means putting your money in multiple types of investments (called "asset classes"). Doing this often reduces the volatility (up-and-down performance) of your portfolio. A very basic diversified portfolio might contain the following investments:

  • Stocks and mutual funds (most risky, but with the highest potential growth)
  • Bonds, including treasury and corporate bonds (less risky, but with lower potential growth)
  • Certificates of deposit (CDs) and money market funds (least risky, with very small growth)

Why diversify? Balance risk and growth

Portfolio diversification has many goals, but the first is to balance risk. Some asset classes, like stocks, have both a high potential return and a high amount of risk--they could double or triple or they could fall to a fraction of the original price. Other asset classes, like CDs, have low potential returns and very little risk. Some individuals consider their home to be an asset in their portfolio. While traditionally a home has been considered a very safe investment, recent experience teaches us that it can actually be quite risky.

Another goal for portfolio diversification is to hold assets that tend to move in different directions. For instance, yields on bonds will often go up when stock market indexes are falling, and vice versa. International stocks and bonds may move up when the U.S. stock and bond markets are falling, and vice versa. And when yields on savings accounts are highest, growth (and, thus, stock prices) might be depressed because of high corporate borrowing costs.

Diversify not just among, but within asset classes

While many investors feel that maintaining a balanced portfolio with an appropriate mix of stocks, bonds and short-term investments is an accomplishment, the industrious investor will also attempt to make a balance of investments within asset classes. For instance, a larger portfolio might accommodate both U.S. Treasury bonds and a high-yield corporate bond fund within the "bond" asset class; and both a stock market index fund and an assortment of individual stocks within the "stocks" asset class. Or, you might have both a small-cap stock fund and a blue-chip stock fund in your portfolio in addition to CDs, bonds and other investments.

The larger a portfolio, the more flexibility you will have to create a balance among asset classes, risk profiles and growth curves. A classic basic example of stocks whose growth curves tend to be inverse (in other words, one moves up while the other moves down) would be an oil company and an automobile company. Theoretically, when oil prices are highest and profits are brightest for oil companies, fewer customers will buy new cars, depressing the profits for automobile companies.

Never ignore risk when diversifying

As interesting and intellectually stimulating as it might be to design a portfolio in which growth prospects for a number of investments are considered and balanced, it is important to never forget that risk, or volatility, is the most important diversification concern. For instance, a portfolio that was equally invested in mutual funds, bond funds, savings accounts and international stocks could be very risky if each fund was very aggressive (small-cap growth stock funds, matched with high-yield bond funds, along with a high-yield money market account at a poorly managed bank, for instance).

Hedge-fund math always includes the "beta," or relative expected risk, of a given investment. You don't have to be able to run these complicated algorithms to realize that you should always have some of your money in relatively safe investments, like CDs and money-market funds. But you probably already knew that!

This Guide to Money answer includes the topics: Invest.

 
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