Key takeaways
While investors assessing their investment options often focus an asset’s return potential, an equally important consideration is how to manage portfolio risk.
One key to managing risk is to follow the adage, “don’t put all your eggs in one basket.”
Diversification is the practice of building a portfolio with a variety of investments that have different expected risks and returns. The goal is to provide a smoother path for achieving your goals over time.
A diversification strategy within your portfolio is designed to spread the risk of negative performance in a specific investment by owning a mix of assets that have differing characteristics.
No matter how strongly you feel about the prospects for a specific investment, a variety of factors can affect its performance. These could include unforeseen economic changes (i.e., high inflation, a recession); changes in the competitive market landscape; or other factors that can impact a security-issuing business or entity.
By owning different types of investments that typically generate varied performance across different environments, you can position your portfolio to be more resilient during challenging market periods. Over your investment time horizon, diversification can help provide a degree of stability to your portfolio.
A diversification strategy can help protect you against circumstances that can negatively impact specific investments.
“In a typical environment, if the Federal Reserve is cutting interest rates to help spur a struggling economy, stocks may be encountering headwinds, but bonds tend to perform well as rates decline,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “We don’t always see stocks and bonds move in opposite directions, but it happens frequently.”
As an example, let’s look at industry-specific risk found in energy stocks. If the price of oil falls, multiple corporations in the oil and gas industry may see their share prices fall. If you’ve invested in other industries or other types of assets, the potential decline in energy stocks’ value would likely have less of an impact on your portfolio.
Diversification does not guarantee returns or protect against losses and can help mitigate some, but not all, risk. For example, systematic risks – which include inflation, interest rates or geopolitical events – can cause instability in markets and affect the broader economy and market overall.
It’s important to consider the correlation between the investments in your portfolio. Even if you own many different investments, if they all trend up or down together, your portfolio isn’t appropriately diversified. For instance, high-yield bonds often have a positive correlation with stocks. Therefore, a portfolio made up entirely of high-yield bonds and stocks is not well diversified.
“In a typical environment, if the Federal Reserve is cutting interest rates to help spur a struggling economy, stocks may be encountering headwinds, but bonds tend to perform well as rates decline,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “We don’t always see stocks and bonds move in opposite directions, but it happens frequently.”
Historically, a mix of stocks and bonds provides a level of diversification that can smooth investment performance. The returns of a portfolio featuring a combination of 60% stocks (based on the S&P 500) and 40% bonds (represented by the Bloomberg U.S. Aggregate Bond Index) are less volatile over time, compared to an all-stock portfolio. Maintaining more consistent performance year-over-year is likely to help individuals keep assets actively invested.
Investing offers several primary asset classes to choose from, including:
These asset classes tend to generate different returns and are subject to varying levels of risk. Including investments across asset classes is a starting point to build a diversified portfolio. A good diversification strategy will contain at least two asset classes.
More significant diversification is possible within asset classes. Methods of diversifying within an asset class include:
Even within an industry, it can pay to be diversified. “Some company-specific issues can arise that differentiate performance between two companies that are in the same industry,” says Haworth. He points to the recent performance of two prominent semiconductor stocks. “Nvidia has been a star performer in the market, while Intel is cutting back its workforce,” says Haworth. Year-to-date through August 15, 2024, Nvidia stock is up 148% while Intel stock is down 59%.
It’s also a good idea to consider location and global exposure as a part of your diversification strategy.
For example, if you only own U.S. securities, your entire portfolio is subject to U.S.-specific risk. Foreign stocks and bonds can increase a portfolio’s diversification but are subject to country-specific risks, such as foreign taxation, currency risks, and risks associated with political and economic development. However, in periods when U.S. stocks may be facing headwinds, global markets may perform better.
Location can matter in terms of investments in tax-exempt municipal bonds. “Bonds issued by the state of Illinois and the city of Chicago have recently run into payment and credit problems,” says Haworth. “Investors based in a state trying to capitalize on state tax exemption of income generated by those bonds should also consider diversifying into bonds from issuers based in other states to protect against issuer risk.”
If you’re seeking additional diversification, other types of assets should be considered:
Even the most diversified portfolio requires periodic rebalancing. Over time, certain investments will gain value, while others decline. Rebalancing is a negotiation between risk and reward that can help your portfolio stay on track amidst the market highs and lows.
There are certain situations that might trigger rebalancing, including market volatility and major life events. Read more about when to rebalance your portfolio.
Your views about investment risk can impact your diversification strategy. Generally, the longer your investment timeframe, the more you can weather short-term losses and capitalize on the potential to capture long-term gains. There are a few questions that can help you determine your risk tolerance.
A diversification strategy is designed to help your investment portfolio generate more consistent returns over time and protect against market risks. Review your portfolio to determine if it's appropriately diversified for your financial goals, risk tolerance and time horizon.
Whether you want to invest on your own or with personalized financial guidance, we have investing options to meet your needs.
Why is diversification important in investing? Because risk never disappears—even in times of economic growth.
Bonds are a common investment in times of economic uncertainty, but they also play an important role in diversifying your portfolio.
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