Diversification is the principle of spreading your savings across different asset classes so that your exposure to any one type of asset and its associated risks is limited.
Think of diversification like a store that sells both sunglasses and umbrellas. On sunny days, they sell sunglasses. On stormy days, they sell umbrellas. “By selling both items—in other words, by diversifying the product line—the vendor can reduce the risk of losing money on any given day,” explains the U.S. Securities and Exchange Commission.
The practice of diversification is designed to help reduce the volatility of your portfolio over time. Learn more about the basics of portfolio diversification and how you can apply them to your financial future starting today.
What Is Portfolio Diversification?
Diversification of your portfolio splits risk among various types of assets. A diverse asset mix may include stocks, bonds, money market funds, certificates of deposit (CDs), real estate, and precious metals. Diversification helps even out the ups and downs of asset performance over time.
“With any [portfolio] strategy, it’s important that you not only think carefully about your asset allocation and make sure to diversify your holdings when you establish your portfolio, but you also must stay actively attuned to the results of your choices,” notes FINRA, a nonprofit organization that oversees broker-dealers.
In addition to various portfolio results, major life events can also prompt a diversification reassessment. Marriage, separation, divorce, a career change, a new baby, or the death of a loved one each presents an ideal moment for reevaluating your asset allocation.
Why Is Portfolio Diversification Important?
Portfolio diversification provides a balance between risks and rewards by ensuring that your portfolio doesn’t depend on one type of asset. The opposite of asset diversification would be putting 100% of your money in a single asset class, like stocks or real estate.
Everyone’s comfort level with diversification differs depending on age, risk tolerance, and other factors. But here’s one example of a diversification strategy:
- 25% in equities like stocks and bonds
- 20% in cash
- 20% in precious metals, such as gold and silver
- 15% in fixed income
- 10% in real estate
- 10% in other asset types
Small Steps You Can Take to Diversify Your Portfolio
To help make sure you and your portfolio are on the right track, consider taking these three small steps toward diversification.
1. Examine Your Portfolio.
Before you know where to go, you need to figure out where you are. To make sure your portfolio is correctly diversified, take a close look at what’s in your portfolio. Does your portfolio lean heavily toward cash? Do you have enough stocks? Are you lacking precious metals entirely? Experts recommend allocating anywhere from 10 to 25% of your portfolio toward tangible assets like gold and other precious metals. Based on this assessment, you may want to switch your asset allocations.
2. Dive into the Asset Categories.
In Diversification 101, the U.S Securities and Exchange Commission explains that “a diversified portfolio should be diversified at two levels: between asset categories and within asset categories.”
Dig deeper into your portfolio and explore different aspects of each asset category. Do you have the right mix of equities, reflecting an array of rates of return? Do you have too much stock in the tech sector? Do you have too much silver and not enough gold in the precious metals portion of your portfolio?
3. Regularly Rebalance Your Portfolio.
Based on changing market conditions, shifting priorities, life events, and other factors, you should consider rebalancing your portfolio at least twice a year. For instance, you may decide to temporarily shield yourself from rising inflation by increasing your allocation in precious metals. Or you may realize that you want to retire even sooner than you’d planned, so you need to get more aggressive with your portfolio to achieve financial objectives even earlier.
As CNBC notes, someone “who’s approaching retirement might be more interested in protecting themselves from market gyrations while a younger [person] might have a stronger stomach for risk and higher returns over time.”
Jason Kephart, associate director of the multi-asset and alternatives strategies team at Morningstar, adds that when you’re younger, “You want equity risk when you have a time horizon that’s long.”
Financial literacy and portfolio diversification go hand in hand. Head to our Resource Library and download your free special report, “The Unquestionable Case for Portfolio Diversification,” from U.S. Money Reserve.