What is portfolio diversification?

Portfolio diversification is an important strategy for managing potential risk in your investments and income streams. While many people think of portfolio diversification just in terms of stock and bond market investments (i.e., investment portfolio), true diversification can include a variety of assets and products, including real estate, life insurance, and annuities in your overall portfolio.

What is diversification?

Whether you’re a seasoned investor or just getting started, have multiple brokerage accounts or just one IRA, it’s important to understand the role and value of diversification in a healthy portfolio of assets.

Diversification is a strategy that involves spreading out your investments to limit the risks inherent in any single stock or asset. Think of the adage “Don’t put all your eggs in one basket.” Instead of investing all your available wealth in one or two things, you spread it over a large variety of options, making it more resilient to changes. That should include looking outside of traditional stock market investments, as well. Real estate has become a common way to diversify, and other products like life insurance or income annuities can help ensure you have safe returns and cash flow on your investments.

Is diversification a good strategy?

Every investor has different needs, but diversification is widely considered a good strategy for portfolios. Diversification can be an effective tool that allows you to benefit from the potential upside of multiple investments while mitigating unfavorable outcomes. For long-term investors, there is little downside. However, let’s recognize that there is no guarantee that any strategy, including diversification, will be successful. 

Different diversification strategies

There are many ways to diversify a portfolio. The most obvious is to divide your investments into different stocks and sectors. You can do this on an individual basis, or with options like mutual funds or exchange-traded funds (ETFs), which hold many stocks in the same investment bucket. In addition, there are different asset classes. Here’s a list of some of the most common options:

• Stocks: Shares of corporations. They can be purchased separately or bundled and held in index funds, mutual funds, or ETFs (exchange-traded funds.
  
• Bonds: Government bonds, corporate bonds, municipal bonds, and Treasury bills.
• Cash equivalents: Money market funds, certificates of deposit (CDs), and short-term Treasury bills.
• Real estate: Residential, commercial, or rental properties, as well as real estate investment trusts (REITs).
• Commodities: Gold, silver, oil, natural gas, agricultural products, and precious metals.
• Other products: Anything that has the potential to accumulate value over time can be an important part of your diversified strategy. Art is a common example. The cash value of life insurance is another.

Is there a way to measure diversification?

Yes, there are several methods. One commonly used metric is the correlation coefficient, which measures the relationship between two different investments as a number between +1 and –1. A correlation of +1 means that if one investment rises, the other will almost certainly rise, too. A correlation of –1 means that if one investment rises, the other will almost certainly fall. A correlation of zero indicates that the rise or fall of one investment will have no effect on the other. This correlation can be used to create more resiliency and greater diversification in a portfolio. There are other ways to measure diversification as well. These can be valuable tools, but they can also be complicated.

Why do I need portfolio diversification?

Simply put, to limit your risk. The purpose of diversification is to avoid relying too heavily on any single investment or market segment, which can be costly if the investment you have chosen performs poorly.

Risk management:

Portfolio diversification is essential for long-term investors, who need to manage risk effectively. By spreading investments across different asset classes, sectors, and geographic regions, you can create a more robust and more resilient portfolio. That way, if there is bad earnings data for a single company, if there is a local economic downturn, or if new regulations affect a particular sector, the impact on your portfolio will be limited.

Protection against market fluctuations:

Another key benefit of portfolio diversification is greater stability on a day-to-day basis. We all understand that investments can go up and down every day—indeed, every millisecond. The value of single stocks or assets can vary wildly in the short term if, for instance, there is significant news about a company or a change in investor sentiment. Diversification has an “evening” effect on your portfolio, helping to reduce wide swings in your assets and worth.

Long-term growth:

Seeking out steady, predictable growth has a better outcome for the vast majority of investors than betting on flashy investments. A diversified portfolio will give you a foundation of stable and reliable investments that can weather various economic conditions, enabling you to position yourself for sustained growth over time.

How do I diversify my portfolio?

Diversifying your portfolio can be as complicated or as simple as you want. At its most basic, all you need to do is select a wide variety of investment choices, both in the stock market and outside of it. You might simply invest in assets that have diversification built in (like index funds) and let them grow. At the other end, you could spend hours each day, looking over the news, weighing each investment choice, and regularly checking in on your financial objectives. Both approaches are valid and have different benefits. How you go about diversifying your portfolio is entirely up to you. In addition, it’s important not to overlook products that allow you to reduce risk and achieve your financial goals in different ways, like life insurance that can protect your loved ones if something happens to you and annuities that can offer guaranteed retirement income for as long as you live.

Consider your investment goals

With any investment, it's crucial to consider your financial goals and develop a strategy. Are you aiming for long-term growth, wealth preservation, or income generation? Each may require a different level of diversification and/or risk tolerance. It’s also important to consider how long you have until retirement. Many advisors recommend that the closer you are to retiring the more you should consider relatively stable and predictable assets. By aligning your diversification strategy with your investment goals, you can create a portfolio that suits your individual needs.

Other products for diversification

Outside of traditional investments, there are several important products that help you plan for your desired retirement and reduce your risk. Take whole life insurance, for example. It offers a lifetime of stability and protection for you and your family, plus cash value growth, which can act as an additional asset within your portfolio. Cash value grows over time and can be used during your lifetime (though accessing your cash value reduces death benefit and available cash surrender value of the policy). Annuities are another product to consider for retirement. They can provide a steady stream of income for life, complementing other retirement savings like 401(k)s. Adding these products to your portfolio can enhance diversification and provide additional avenues for long-term financial stability.

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