When people talk about a diversified portfolio, what exactly do they mean? Diversification in its most simple terms means to spread risk around so that when bad things happen, you aren’t at a total loss. If you’re at the grocery store with a partner and you each go into a different line with plans to join up at the register of the fastest cashier, that’s diversification.
When you plan your long-term investment strategies around historically successful markets and up-and-coming stocks, that’s also diversification.
The purpose of diversification in investing is to maximize your return by investing in different areas that could each react differently to the same events in the market. Although it doesn’t guarantee to prevent losses, diversification is how you reach your long-term financial goals while minimizing risk.
You’ll never be able to totally eliminate risk – the 2008 stock market is proof of that – but you can lessen the blow by diversifying your investments across a few asset classes.
Depending on your net worth and the level of risk you’re willing to take on, this 2016 survey by Federal Reserve is a fantastic guide to how others have distributed their own assets.
By including different asset classes in your portfolio, like stocks, bonds, real estate, and cash, you increase the probability that some of your investments will provide returns if the others lose value.
How do you build a diversified portfolio?
Step 1: Figure out your needs and your risk tolerance. A newlywed grad student has much different needs and a much different risk tolerance than a middle aged parent with not that much in an old IRA.
In the same vein, risk tolerance will vary from person to person and situation to situation. Greater returns come at the expense of greater risk. For example, the grad student that won't have to depend on their investments for income, can afford to take greater risks. On the other hand, the person nearing retirement needs to focus on protecting their assets and drawing income in a tax-efficient way.
Step 2: Build your portfolio. Once you’ve decided what you need and how risky you’re willing to get, you can begin to assemble your team of investments. Stocks, bonds, mutual funds, ETFs, and cash reserves are all assets that you can mix up to serve your needs. A super conservative portfolio could be almost three-quarters bonds and CDs, which are notoriously safe, with the remaining quarter into stocks and cash.
A more aggressive portfolio that is exposed to more risk, but poised to grow with the market, could be more than half stocks and just one-third assets like bonds and CDs.
Step 3: Review and rebalance. There’s no sense in trying to time the market, it just doesn’t work. Instead, review your holdings and your plan every few years – that’s right, years, not weeks or months. Has anything dramatically changed? Are you better or worse off than you were when you made the plan? Make changes if needed and let your plan evolve along with your life.
Investing can be profitable and fun. There’s no magic trick or just-right number of things to do, it’s a process. Luckily, it’s a process informed by years of research and studies. By spreading your risk out and diversifying your investments, you can grow your nest egg over time – even in the worst of times.