Why it’s important to diversify your investment portfolio
Investing is one of the best ways to build wealth and achieve your long-term financial goals. But what to invest in? Although there is no right answer for everyone, there is one principle that can guide your investment decisions: diversification.
“No matter what your goal, diversification is the key to investing,” says Corbin Blackwell, a senior financial planner at Betterment.
As with many things in the world of finance, diversification seems complicated at first glance. But we spoke with two investment experts to help you understand exactly what diversification means, how diversified your portfolio should be, and how to start diversifying your portfolio now, even with a small amount of money.
What does diversifying your portfolio mean?
When you diversify your portfolio, you incorporate a variety of different types of assets into your portfolio. Diversification can help reduce your portfolio risk so that the performance of one asset or asset class does not affect your entire portfolio.
There are two ways to diversify your portfolio: between asset classes and within asset classes. When you diversify asset classes, you spread your investments across multiple types of assets. For example, rather than just investing in stocks, you can also invest in bonds, real estate, etc.
When you diversify within an asset class, you spread your investments across many investments within a certain type of asset. For example, rather than buying shares of one company, you would buy shares of many companies of different sizes and industries.
Why is it important to diversify
The main purpose of diversification is to spread your risk so that the performance of one investment is not necessarily correlated to the performance of your entire portfolio.
“Remember the old saying, ‘don’t you want to put all your eggs in one basket?'” says Delyanne Barros, an investment expert and the founder of Delyanne the Money Coach. “Now imagine that basket is a stock. Putting all your money in one company or just a handful of companies can be extremely risky when it comes to investing. If one of these companies fails or their performance suffers, your investment will also suffer.
You don’t want the success of your investment portfolio to hinge on just one company, so you can reduce your risk by spreading your investments across many different companies and even other asset classes.
Moreover, different asset classes – and even different assets within the same asset class – behave differently depending on market conditions. Having a variety of different investments in your portfolio means that while part of your portfolio is down, not all of it is necessarily down.
Finally, diversification can help you combine assets of different risk levels in your portfolio. For example, stocks have historically produced higher returns than bonds or cash, but they also carry more risk. On the other hand, while bonds don’t produce the same high returns as stocks, they can hedge some of your portfolio risk during years when the stock market is down.
How diversified should your portfolio be?
There is no magic formula that can tell you exactly how diversified your portfolio should be. However, a rule of thumb is to include investments in your portfolio whose returns are uncorrelated to each other. This way, if a market event affects one part of your portfolio, it either doesn’t affect the whole, or it has the opposite effect on another part of your portfolio.
As we mentioned earlier, you can diversify between or within asset classes. First, include assets other than stocks in your portfolio. Bonds are a popular addition to many investment portfolios, but you can also include real estate or other alternative investments. Second, make sure your stock investments are diversified. You can achieve this in different ways:
- Invest in companies from different stock market sectors
- Invest in companies of different sizes (large, mid and small capitalization)
- Invest in national and international stocks
One mistake you might inadvertently make as an investor is putting your money in multiple funds that hold essentially the same assets.
“A common misconception is that people think they have a lot of funds, and therefore are diverse,” Blackwell said. “Having more positions in your portfolio does not mean you are more diversified. Good diversification is having different segments of the market that do not behave in the same way. »
For example, you might invest in an S&P 500 index fund and a total stock market index fund, thinking you’re getting exposure to a wide variety of investments. But about 75% of the total U.S. stock market is made up of stocks that are already in the S&P 500, according to Morning Star. So, instead of further diversifying your portfolio, you’ve invested twice in most of the same companies.
“You want assets that behave differently from each other, whether they’re inverse or completely independent of each other,” Blackwell said. “Just having a lot of mutual funds, stocks, or ETFs doesn’t mean you’re well-diversified, based on what’s in them.”
Remember that the level of diversification that’s right for you also depends on your financial goals, time horizon and risk tolerance. As these things change over time, so should your asset allocation. Generally, the closer you get to retirement, the less percentage of your retirement fund needs to be kept in stocks.
Changes in market conditions can also affect your level of diversification without you realizing it. If an investment or asset class is doing particularly well over a period of time, it may come to represent a larger portion of your investment portfolio in terms of monetary value, even if the number of shares you own remains the same. If this happens, you may want to buy or sell some assets to restore your portfolio to its original asset allocation. This is called rebalancing.
How to start diversifying today
One of the easiest ways to create a diversified investment portfolio is to invest in mutual investments. A pooled investment is a single investment fund that holds hundreds, if not thousands, of individual investments.
Exchange-traded funds and index funds are popular types of mutual funds, and you can use them to gain exposure to a wide range of assets with a single investment. Some of the most popular ETFs and index funds span the S&P 500, NASDAQ, or even the total stock market.
Another tool that can help you diversify your portfolio is a robo-advisor. Investors can use robo-advisors to build a diversified portfolio without having to research and select their own investments. When you sign up for a robo-advisor, you share information about your financial goals and the robo-advisor builds a diversified portfolio on your behalf, automatically rebalancing it over time.
You can easily diversify your portfolio using index funds and robo-advisors, even with a small amount of money. Just be sure to choose a diverse selection of funds that suit your financial goal and time horizon.
A final tool that makes it easier to diversify your portfolio is fractional shares, which are just part of a single stock.
“Fraction shares allow you to buy as much as you can afford of a single stock and still get the diversified exposure you want in your portfolio,” Barros said. “Investors can literally start investing with a dollar. Brokers like Fidelity and Charles Schwab are a few examples that offer fractional shares.
Tesla shares, for example, was trading at over $1,000 per share in the second week of January 2022, making it unaffordable for many investors. But with a broker that offers fractional shares, you can buy just part of a stock to fit your budget.
Do you need a minimum amount invested?
The good news is that there is no minimum amount of money needed to create a diversified portfolio. In the case of an ETF, the price needed to start is simply the cost of one unit of the fund. In some cases, the price of an ETF share can amount to hundreds of dollars. But just as you can buy fractional individual stocks, you can also buy fractional ETF stocks from certain brokers.
Some brokers – Vanguard being a well-known example – require a minimum investment on their index funds. But many other brokers allow you to invest in index funds with no minimum investment.
If you choose to invest with a robo-advisor, you will also be able to start with a small amount of money. It depends on the company, but some robo-advisors require a minimum investment of just $10.
It is important to note that although the actual amount required to start investing may be low, there are a few financial milestones you may want to reach before you start investing.
First, make sure you can meet all of your financial obligations each month. If you’re having trouble paying bills, you may want to wait until you’re in a more stable financial position before opening a brokerage account. Likewise, consider building up your emergency fund first. Although the recommended amount for an emergency fund varies, most experts say you have at least three to six months of living expenses in the bank.
Finally, if you have high-interest debt, such as credit cards or payday loans, it’s wise to pay them off before using your disposable income to invest. The interest rates on these types of debt can be higher than your potential investment income, which means prioritizing high-interest debt actually results in a higher return.
Once you check off these tasks on your financial to-do list, you can be sure to put money in a brokerage account every month. Even if you only have a small amount to start with, your investment can still earn you a lot, especially if it has many years to grow.