They say you shouldn’t put all your eggs in one basket, but why is that? Well, thinking about the phrase literally, if you dropped your basket, all your eggs would break. But if you split up those eggs among a few different baskets, dropping one won’t affect the eggs in the others. When it comes to investing, portfolio diversification, a critical strategy for reducing your risk, works a bit like that.
What is portfolio diversification?
Diversification is an investing technique that involves allocating your investments across different types of asset classes, industries, and geographies. That means investing in a mix of stocks, bonds, funds (like mutual funds and ETFs), and other assets in order to optimize your portfolio based on the level of risk you decide to take on.
How does a diversified portfolio reduce risk?
Having a portfolio of diversified investments limits your risk of loss while still maintaining a balance that aims to generate returns. It allows you to not be overly dependent on the success of one single company, industry, location, or economy. When you’re diversified, you can more strongly weather the ups and downs of market volatility.
Here’s another way to think of it: You invest 10% of your portfolio in one stock and spread the other 90% across a mix of bonds and ETFs. If the company behind that stock fails, only a minor portion of your portfolio will be affected. But if 50% of your portfolio is invested in that company, you could experience significant loss if its stock plummets.
Can a diversified portfolio help in a bear market?
During a bear market, diversification can’t guarantee you won’t experience loss, but it is a tool that can help balance out your losses in the midst of volatility. This is because different types of asset classes, industries, and more will react to the market in varying ways. For example, when the equities market is down, the bond market tends to rise. So, if you balance out your stocks and index-tracking ETF investments with bonds, those bonds can act as a hedge to help keep your portfolio afloat even if major indices are experiencing a bear market.
Can a diversified portfolio eliminate all risk?
When you invest in the market, the chance of risk always exists. But that doesn’t mean you can’t limit the amount of risk your portfolio is exposed to. That’s because as an investor, you’ll face two kinds of risk: systematic and unsystematic.
Systematic risk is based on factors like inflation, exchange, and interest rates, as well as social and political instability and events. This kind of risk affects the market as a whole, rather than specific companies or industries — making it something all investors are inherently exposed to.
Unsystematic risk is the kind that can be specific to an individual company, industry, location, economy, etc. This means you can limit it by investing in assets that are not all affected by the same business, financial, economic, or market happenings — a.k.a. diversifying your portfolio.
How can you diversify a portfolio?
To build a diversified portfolio, you probably want to start with an understanding of your risk tolerance to help you decide on an appropriate asset allocation. For example, if you have a high risk tolerance, you may be able to initially invest more heavily in stocks than bonds. With a lower risk tolerance, you might consider a more conservative approach, and your portfolio could be more heavily weighted with bonds and other fixed-income securities.
From there, you’ll want to explore different types of stocks, mutual funds, and ETFs. Mutual funds and ETFs can be a smart way to enhance the diversification within your portfolio, since these investments are funds made up of numerous underlying securities.
It’s important to remember to diversify across industries and geographies, too. You could invest in an ETF, some corporate bonds, and a stock or two that are all related to the tech sector — and while your assets are diversified, they could all be susceptible to volatility in that sector. Same goes for diversifying across locations. A mix of investments that span different geographical areas and countries can help spread your risk even further.
If diversifying and managing your portfolio sounds like too much work, research, or upkeep, you don’t have to do it alone. With a cash-enhanced Managed Portfolio from Ally Invest, we’ll build a diversified portfolio for you and automatically rebalance it so your allocation stays in line with your goals. Plus, with the 30% cash buffer, a portion of your portfolio will always be cash — further reducing your risk during volatility.
Don’t wait to diversify.
If you wouldn’t put all your precious, metaphorical eggs in one basket, you certainly don’t want to put your very real money into one investment or sector. By diversifying through different types of investments, an array of industries, and varying geographies, you can build a stronger portfolio that’s better prepared to withstand a fluctuating market — or a klutzy basket holder.
Want to learn more about how we build diversified Managed Portfolios?