Diversification is something financial planners bring up constantly when evaluating retirement portfolios. Yet for many investors, the term is vague at best. If you don’t quite understand what it means or why you should care, you’re not alone. Even among financial professionals, diversification can have multiple definitions and suggest different strategies, which complicates things further.
Even so, diversification remains critical to retirement and most—if not all—other investment strategies.
Here’s what you need to know.
What it means to diversify
Imagine you have an apple tree. This tree provides all your food. But if you harvest apples in the fall, what are you going to eat in the spring or summer? Planting some corn might be the answer. Buying a meat source that isn’t susceptible to the seasons could also ensure you have food, no matter what happens to the apples.
The same idea works for investing. If your retirement nest egg is heavily invested in U.S. stocks, it might also be a good idea to have some exposure to international markets. Maybe you’ll sprinkle in stocks of different-size companies, or “market caps.” You might also invest in “fixed income”—government and corporate bonds—or even commodity funds that hold gold, silver, copper or energy investments. By spreading out the kinds of assets you invest in—congratulations, you’re diversifying!
The idea behind diversification is that if one part of your portfolio struggles, the others may help protect or even grow your overall investment. This reduces the overall risk you take on, and helps ensure you can continue, well, eating through all four seasons.
Cut through the confusion
This easy-to-understand concept is easy to muddle. That’s because it isn’t entirely clear what constitutes a “diversified portfolio.” For example, must it include all the “major” asset classes (stock, bond and cash investments)? What about commodities like gold or silver? Real estate or artwork? Safer U.S. Treasuries along with riskier corporate “junk” bonds?
Also, just how many investments are enough for proper diversification? The answer could be, less than you think: In 1977, New York University researchers determined Opens in a new window that, based on “standard deviation” (how far an investment strays from the norm), a pool of more than 150 stocks doesn’t perform much differently from one that has just 20 to 30 stocks. Thing is, while mutual funds and exchange-traded funds (ETFs) are diversified, most hold far more than 20 or 30 investments. (Many funds have to do so—they aim to mirror the performance of “indexes” that reflect sections of the market. But other “actively managed” funds invest according to their own strategies and research.)
Even so, understand that while funds are naturally diversified among many investments, they often focus on certain types of investments, like bonds issued by emerging-market governments or stocks of mid-size U.S. companies. So despite how many investments a fund may hold, you should consider diversifying across several different funds.
Quick ways to diversify
When establishing your 401(k) or other workplace retirement savings plan, you might have been asked if you want your contributions to go into a target-date fund or a lifestyle fund. These are “funds of funds”—they invest in many funds with different strategies. The difference is their approach:
- Target-date funds diversify your portfolio based on when you expect to retire. They automatically change their asset allocation over time, generally focusing less on riskier investments, such as stocks, as you near retirement.
- Lifestyle funds diversify your investments based on other factors, such as your risk profile or when you need to access your money. Funds like these can help ensure your portfolio remains diversified without you ever lifting a finger.
(You still should check your account periodically to ensure the fund’s strategy continues to match yours.)
If you instead selected a few different investment options on your own, you should check your account even more regularly. The reason: Market performance can cause your portfolio to stray from your original strategy.
For example, maybe you’d planned to have 70% of your portfolio in stock funds, but yours have done so well, they now represent 80%. In that case, you “rebalance” by selling enough shares of stock funds and buying enough bond fund shares to return to your target investment mix.