To be sure, diversifying your portfolio doesn't mean you'll never suffer a loss, nor that you'll achieve a specific return. However, this strategy might help reduce volatility, making the ups and downs a little less nerve-racking.
Consider a portfolio of two equal investments: One asset earns an annual return of 10%, and the other returns 6%. The overall return will be 8%. Or, if one asset returns 7% and the other has a loss of 3%, you'll end up with an overall return of 4%.
Most investments aren't perfectly correlated to each other, notes Martin Gruber, professor emeritus of finance with New York University. So, as demonstrated in the portfolio examples above, if one investment moves up, the other might also rise, but at a different rate. Two investments also can be negatively correlated, or move in opposite directions — so when one goes up, the other declines.
By investing in assets that are negatively correlated, you may gain some protection against market drops. When you diversify your portfolio, your returns generally won't mimic those of the highest-returning asset — but they also are unlikely to fall as far as your lowest-returning asset.
Holding a mix of stocks, bonds and cash can help you move toward your financial goals.
A diversification strategy also can help guard against emotional investing, says Rodney Ramcharan, associate professor of finance and business economics at the University of Southern California. When one sector — say, technology stocks — is doing well, investors may be more eager to get into the market. That typically drives stock prices higher, even though there's no guarantee the sector will continue to climb.
Conversely, “if you can commit to diversification, and ignore trends and fashions [in investing], you'll be better off,” Ramcharan says. Nobody knows how any one investment will perform down the road. Diversification is an “attempt to be humble about what you can and can't know,” he adds.
So how can you best diversify your portfolio?
Because everyone's situation is unique, there is no one answer for all investors. For instance, if you plan to tap into your money in the next five years, you may need a more conservative mix of investments than if you won't be touching your savings for decades.
Holding a mix of stocks, bonds and cash can help you move toward your financial goals. You can also choose diversified funds that gradually modify their asset allocation over time, typically shifting from a focus on growth to a goal of protecting your portfolio. This strategy could make sense if you are saving for long-term goals, such as retirement or college costs.
Limits to diversification
While diversification remains a key principle of sound investing, as noted previously, it's not a guarantee against losses. For example, when there is a major hit to the stock market, the benefits from diversification can lessen. Why? The major markets tend to move together, Gruber says. So if you are holding both domestic and international stocks, for example, both could take a dive at the same time.
That said, your fixed-income holdings could help cushion the blow from a stock market swoon.
Either way, Gruber adds, many markets that have seen deep declines will return to their pre-shock levels within about a year.
Another potential limit to diversification is cost. “Every time you buy something, you incur a transaction cost,” Gruber notes. Again, one way to get the benefits of diversification while keeping transaction costs in check is by holding funds that will automatically diversify for you.
In investing, surefire solutions don't exist. However, diversification can reduce heartburn-inducing portfolio volatility while still allowing for reasonable returns.
Just remember: Diversification does not protect against a loss in declining markets or ensure a profit.