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What is a diversified portfolio and why is it important?

What we'll cover

  • What portfolio diversification is

  • Why diversification matters

  • Building a diverse portfolio

They say you shouldn’t put all your eggs in one basket, but why is that? Well, thinking about the phrase, 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 does it mean to diversify your portfolio?

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.

What is the importance of diversified investments?

Having a portfolio of diversified investments may limit 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 may be able to weather the ups and downs of market volatility .

How does a diversified portfolio reduce risk?

Consider this scenario: 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, it’s possible that 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.

Diversification may also help balance losses during a bear market. 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 with bonds, those bonds may act as a hedge to help keep your portfolio afloat even if major indices are experiencing a bear market. 

Having a portfolio of diversified investments may limit your risk of loss while still maintaining a balance that aims to generate returns 

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 an Ally Invest Robo Portfolio , 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.

Ally Invest's 4 custom portfolio choices

We offer four customized portfolio options to meet a variety of investor needs and preferences. Choose the portfolio that aligns with your time frame and goals and we’ll handle the diversification.

Image shows Ally Invest portfolio choices; choose the one that best matches your future goals. (Core) this standard portfolio is highly diversified across domestic, international and fixed-income assets. Choose the amount of risk you can tolerate. The core portfolio is a great choice for the hands-off investor. (Income)For investors most focused on yield and income, this portfolio type offers higher dividend yields with a more conservative risk profile. (Tax optimized) You can help maximize your investments if you make after-tax contributions to an investment account with this type of portfolio. It’s a good option for investors who want to use a mix of a tax-advantaged, low-cost ETFs. (Socially responsible) This portfolio type is a great fit for the socially conscious investor and gives greater weight to companies with strong environmental or governance qualities.

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 investing with an automatically diversified robo portfolio or selecting your own mix of 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.

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