Portfolio diversification: What investors need to know

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The classic metaphor still holds up: Diversification helps spread out risk.

© rangizzz, Aliona, ELISA/stock.adobe.com; Photo illustration Encyclopædia Britannica, Inc.

The old adage about not putting all your eggs in one basket is sage advice—especially when it comes to investing. It’s often used to explain diversification, the idea that your money should be allocated to different types of investments rather than concentrated in just one.

Those investments might include stocks, bonds, commodities, or even cryptocurrencies. Diversification also means owning a variety of companies, industries, and regions so you can manage risk without missing out on growth.

Diversification allows you to take advantage of as many growth opportunities as possible. At the same time, it helps you mitigate risk, particularly the risk of losing too much money on any single investment.

Let’s say your employer, as part of your compensation, awards you $10,000 in company stock. The company is doing well, and the price of its stock is rising. You may want to hold on to the stock as it rises.

If that stock is the only one you own, however, you have what’s called a concentrated portfolio. As long as the stock keeps going up, that may seem like a good thing. But no stock goes up forever.

You might decide to sell some of that $10,000 in company stock and use the money to build a more balanced portfolio. That could mean buying a mix of stocks and bonds directly, or using mutual funds or exchange-traded funds (ETFs), which offer built-in diversification by holding many different investments.

By having a diversified portfolio, you’ll participate in the earnings and growth of other companies and industries—not just those of your company. And if your company’s stock should drop, diversification can soften the blow.

Diversification isn’t just a theory; it’s a strategy that plays out over time. The chart in figure 1 shows 30 years of data on average annual returns and single-year highs and lows for major asset classes: stocks, bonds, T-bills, and inflation.

Stocks delivered the highest long-term returns, but with far more dramatic ups and downs than bonds or T-bills. Inflation also showed more variability than many investors might expect. A diversified portfolio helps manage those swings, combining higher-growth assets with more stable ones so you’re not overly exposed to any single outcome.

Even a diversified portfolio needs some love and attention—and perhaps the occasional tweak. Investment pros call it a portfolio review and rebalance. There are two common reasons for the review/rebalance exercise:

1. Concentration creep. Suppose a few years ago, your $20,000 portfolio consisted of two holdings: $10,000 (or 50%) in an ETF that tracks the S&P 500 (SPX) and $10,000 (the other 50%) in a high-flying growth stock, say Netflix (NFLX). By late 2021, the $10,000 in the index would have appreciated about 80%, but Netflix would have soared 260%, as the chart shows.

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THE RISE AND FALL OF THE FAANGs. In the late 2010s through early 2021, the so-called “FAANG” stocks (Facebook, Amazon, Apple, Netflix, and Google/Alphabet) outpaced the broader market S&P 500 (SPX), but their fall in 2021–22 was substantially steeper than the broader market. A portfolio rebalance could have mitigated the impact of the sell-off. For illustrative purposes only.

Source: Barchart.com

At that point, your portfolio concentration would have deviated greatly from 50/50, with Netflix comprising two-thirds of your portfolio:

In this example, a periodic review and rebalance could have prompted you to mitigate your downside risk before tech companies such as Netflix fell back to earth in 2021 and 2022.

2. Your risk profile changes over time. When you begin investing for a faraway goal such as retirement or a child’s college education, you can afford to take some additional risk in search of a higher return. A long-term portfolio can generally ride out the ebbs and flows of the market. But as that goal gets closer—whether you’re nearing retirement or about to start covering education costs—you may want to reduce the risk of a market drop just when you need to start withdrawing funds. In both cases, diversification is a moving target.

There are many ways to diversify. Mutual funds and ETFs make it easy to own a broad mix of investments with just a few holdings. Balanced funds go a step further by combining both stocks and bonds in a single fund.

Lifecycle or target-date funds are another strategy that many retirement-minded investors choose. They offer portfolios of stocks and bonds that adjust over time—from a growth orientation to a less risky composition—as the investor nears the date in the fund’s name (for example, a 2060 fund would be invested mostly in cash by the year 2060).

You could also look into a robo-advisor, an automated service that helps you build and manage a diversified portfolio. It asks a few questions about your goals and how much risk you’re comfortable with, then creates a plan and keeps it updated over time. Most big brokers and fund companies offer this kind of service for an annual fee.

Diversification is a core principle for investors in any market, and for good reason. No one can predict what any investment will deliver over time. But by casting a wide net, investors are more likely to find growth opportunities and avoid steep losses—or at least mitigate the damage from market sell-offs—over the long haul.