Diversification: A Quick Guide For Investors

April 26, 20212 min read
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Hand stacking gold coins across different piles to show diversification in investing

Diversification is an important element for any investor to achieve in their portfolio, but what is diversification, and how can investors achieve it? This guide aims to explain some of the principles behind diversification in investment portfolios, and empower investors to conduct their own due diligence when evaluating their portfolio in accordance with their investment needs. We will also provide an example of a diversified portfolio below.

What is diversification?

One helpful illustration to conceptualize diversification is to recall the food pyramid that nutritionists use to show a healthy diet. Just as your diet shouldn’t contain just vegetables or grains, your portfolio shouldn’t include only one asset class. Many investment advisors and financial principles stress the importance of diversification so that in the event of an under-performing investment or significant macroeconomic issue, your entire portfolio won’t suffer the same fate. 

How do investors typically add diversification to their portfolio?

There are many different ways for investors to diversify their investment portfolios. One key to diversification is finding investments that have low correlations to each other, meaning they have different economic sensitivities and don’t move perfectly in unison together.

Creating an investment portfolio with assets with low correlation to one another may help reduce your exposure to certain  markets and curb your portfolio’s overall volatility. For example, a well-diversified portfolio might include a mix of the below major asset classes, but may also include a variety of investments within each asset class. Here is an diversified portfolio example:

  • US stocks
  • Bonds
  • Foreign stocks
  • Alternative investments (i.e., real estate, marine finance, hedge funds, private equity, art finance, etc.)

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Why is portfolio diversification related to risk?

For investors seeking an additional layer of protection and stability while pursuing investment goals, diversification is a crucial component to reliably plan into the future. What goes up, may come down and since the economy is cyclical, we can confidently say that at some point, a recession and market correction is likely to happen. Investing in a carefully curated selection of assets can help ensure that if one portion of your portfolio takes a hit (such as US stocks) the entire value of your portfolio and your retirement goals won’t necessarily sink alongside it.

The journey to financial health is a marathon, not a sprint. Roadblocks and detours are expected and normal along the way. Diversification, however, is an important key to staying on track and getting the most out of your hard-earned money.