A well-diversified portfolio offers reduced risk and potential return. It’s the classic “don’t put all your eggs in one basket” approach to investing.
Diversification can mitigate investment losses but can also limit the rewards. The key is to diversify in ways that complement your investment goals. Let’s examine three common approaches.
Asset Allocation
One of the key decisions investors must make when diversifying is how to divide their investments among stocks, bonds and cash equivalents like money markets. The proportion of each can differ depending on a person’s time horizon and risk tolerance, or their ability to tolerate losing some money in the short term for the prospect of higher gains over the long run.
The reason that diversification is so important is that different asset classes don’t move in tandem. So, when one type of investment loses value, another may gain, providing a smoother pattern of returns and less anxiety for investors.
People can further diversify by investing in different geographic markets and even different industries within those markets. However, the more a portfolio veers from the traditional stock and bond combination, the greater the potential for risk.
Equity
A well-balanced portfolio is composed of assets that offer varying levels of risk and potential returns. Asset classes include stocks, bonds and cash alternatives. Stocks typically carry the highest risk while offering the greatest potential for growth. Bonds carry less risk than stocks but generally deliver lower returns. While a portfolio can also include precious metals and real estate, these investments tend to carry more risk than the three main asset classes.
Diversification of equity investments doesn’t necessarily require a hodgepodge of individual stocks, mutual funds and exchange-traded funds (ETFs). In fact, many investors find diversification through simple, low-cost products like index or target-date funds and robo-advisers that provide immediate diversification with minimal effort.
While no investment can guarantee against loss, most professionals agree that the best way to reach long-range financial goals is through diversification. A qualified financial advisor can help you create a plan for diversification that works for you. SmartAsset’s free tool matches you with advisors in your area who serve your needs, and you can interview your advisor matches at no cost before making a decision.
Fixed Income
The old adage, “Don’t put all your eggs in one basket,” is an excellent reminder that diversification lowers risk. That’s true for stocks and fixed income investments, which can help stabilize a portfolio when market declines occur.
Bonds are an essential component of a well-rounded investment portfolio. While they can’t protect against a loss in stock markets, their low correlation with equities means that when the stock market falls, bonds tend to decline less than stocks.
TD Ameritrade offers a variety of brokered CDs to help clients diversify their fixed-income portfolios. Our CD Specialists are here to help them find options that align with their investment objectives.
However, today’s elevated credit valuations and inflation uncertainty call into question the degree of ballast and stability that traditional bond allocations can provide in portfolios. As such, we believe it’s important to consider alternative diversifiers that can complement traditional bonds in order to build a more resilient portfolio.
Cash
Diversification is often thought of as the act of dividing investment funds into three general categories: stocks, bonds and cash (or cash equivalents). However, investors should consider a range of diversification strategies, not only within asset classes but also across markets.
For example, let’s say you invest in shares in a single company, such as Apple. If the company shares suffer due to unforeseen circumstances, your entire portfolio could be affected. You could diversify by investing in other technology stocks, but if the overall stock market suffers, your portfolio could still take a hit.
By investing in a diverse set of assets you can avoid the big losses that can be caused by a single investment and enjoy the rewards of those that perform well. This is why many investment professionals recommend a diversified portfolio, which is generally based on an investor’s risk tolerance and timeline and includes stocks, bonds and cash equivalents like money markets or certificates of deposit.