Diversification Strategies for Your Investment Portfolio
5 Min Read | Published: May 29, 2024
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Diversification refers to shifting your investments to help limit your exposure and reduce volatility. See diversification strategies you may want to consider using.
At-A-Glance
- Diversification involves selecting a range of assets across different sectors in an effort to reduce portfolio risk.
- You can diversify across asset classes and many factors within classes, such as industry, market cap, style, geographic location, and more.
- Diversification offers many risk management benefits, but excessive diversification carries the risk of reducing a portfolio’s profitability.
Diversification is key to helping to manage risk in an investment portfolio. While it requires more work than investing in fewer assets, the risk management benefits can be worth it for many investors.
In this article, we’ll explore several diversification strategies, from asset allocation to geographic allocation that you can consider using.
What Is Portfolio Diversification?
Portfolio diversification involves selecting an array of investment types, industries, and other categories to manage and reduce risk. The aim of portfolio diversification is not to maximize potential returns but rather to provide more consistent potential returns.
Note that while diversification is an important part of helping to reduce volatility in a portfolio, it cannot guarantee protection from loss.
Why Is It Important to Diversify Your Portfolio?
The goal with diversification is to help protect your portfolio from fluctuations that could cause a significant loss. For example, if you were to invest heavily in just one asset class or sector, and that sector were to experience an economic downturn, your portfolio could be impacted more than it would be if you were to have spread your investments out.
Strategies to Diversify Your Portfolio
There are a number of different ways that you can diversify your portfolio. Here’s a look at a few options you could consider:
- Consider Your Risk Tolerance
Risk tolerance represents how much market volatility and potential losses you can sustain. A lower risk tolerance could necessitate greater diversification.
- Determine Correlation
Understand how assets move relative to each other based on certain market conditions. This can help you choose the right investment options and the proper allocation of those assets to meet your risk tolerance and goals.
- Diversify by Asset Class
One level of diversification is asset class. Different asset classes may perform differently in the same market conditions (but this will vary and isn’t always the case).
Asset classes include:
- Equities (stocks)
- Fixed-income investments (bonds)
- Cash and cash equivalents
- Alternative Investments: Including real estate, commodities, and more.
By investing in the right mix of assets, you may be able to introduce a level of diversification into your portfolio.
- Diversity Within Assets
You can diversify within assets, too. For example, within:
- Industry or Sector
Different industries within asset classes have different business models and factors that determine success. Investing in stocks across several industries, such as finance, defense, utilities, healthcare, consumer staples, and tech exposes you to a variety of industries.
- Market Cap
Market cap is the total value of a publicly traded security. Large-cap companies tend to be stabler, whereas smaller-cap companies may offer higher risk and higher potential returns as well. Diversification can balance safety with potential rewards.
- Style: Growth vs. Value
Growth securities reinvest profits in growing their value, creating more volatility. Value securities are underpriced based on financial metrics and may pay an income stream (like dividends), but may offer less potential growth.
- Management Style
If investing in funds, you may diversify across passive vs. actively managed funds.
- Industry or Sector
- Consider Geographic Diversification
Geographic diversification involves investing in assets across different geographical regions, including in different states and countries.
This can help to hedge against risks such as:
- Political/geopolitical risk
- Local economic conditions
- Natural disasters that could impact the securities
Meanwhile, it can also gain you access to emerging markets at a risk level you can tolerate.
- Consider Alternative Investments
Alternative investments offer another opportunity to diversify. These include investments like precious metals, real estate, and commodities. These are often used to generate income, hedge against inflation, or explore more volatile markets. However, it’s important for potential investors to understand the risks associated with these investments as well.
- Consider Platform Diversification
Platform diversification involves spreading assets across numerous financial institutions.
For example, one investor may save $500,000 at one bank. Under Federal Deposit Insurance Corporation (FDIC) insurance, only $250,000 is insured. However, if you split that evenly between two banks, each covers $250,000 of your savings, and all of your savings become insured.1
- Rebalance Your Portfolio
Rebalancing involves regularly reviewing your portfolio and buying and selling assets to maintain a target weighting of investments. This helps you avoid letting your portfolio become too heavily weighted in one asset class. It can also help you take potential gains when you earn them (by selling assets that may have appreciated) while buying more depreciated assets at a lower price.
Frequently Asked Questions
How much diversification is “too much” will depend on the investor. The main risk with over-diversification is that it could reduce your portfolio’s returns.2 Excessive diversification may make it hard to track investments and rebalance in a timely fashion.
The Takeaway
Diversification is a key risk management technique for many investors, helping them build a portfolio that could be more resilient to fluctuating market conditions and other risks. The proper amount of diversification varies by individual, but striking the right balance is key.
1 “Understanding Deposit Insurance,” Federal Deposit Insurance Corporation (FDIC)
2 “Over-Diversification: How Much Is Too Much?,” The Motley Fool
Bradley Schnitzer is a writer and email strategist who has covered personal finance and small business topics for over five years. He is passionate about personal finance and helping others understand their money.
All Credit Intel content is written by freelance authors and commissioned and paid for by American Express.
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