What’s the purpose of a diversified portfolio?
The short answer: The better you spread your investments across different assets, the less likely they are to all experience a loss. Or in other words, your aggregate losses will likely be less severe.
To stay strong, your body needs a variety of nutrients from proteins, veggies, and fruits to carbs. And within each of those food groups, different foods offer different vitamins. Carrots are full of vitamin A, while broccoli is a good source of fiber, protein, and iron. The more varied your diet, the more nutrients you’ll be exposed to. A similar concept applies to investing. For a long-term investing strategy, not only can it be a good idea to spread out your investments across different asset classes, like stocks, bonds, and so on, but you can also diversify within each class, and across countries, currencies, and time.
However, diversification isn’t a cure-all, or a guaranteed safeguard. Similarly to how a balanced diet won’t protect you from ever getting sick (we all get ill from time-to-time), having a diversified portfolio doesn’t mean your investments will never drop, or even drop dramatically — Diversification is simply a strategy that can help you prevent losses from being as severe as they could be otherwise, and has the potential to help bring less volatility to your returns.
What does a diversified portfolio look like?
The more varied and diversified your investments are, the better able they are to help you mitigate losses.
There’s no shortage of choice when it comes to where you can invest your money. In addition to stocks and bonds, there are money market funds, real estate, commodities, private equities, and so on. What’s more, within each investment class, you can put your money in different companies, industry sectors, geographies, and currencies.
With a diversified portfolio, the idea is that the more varied your collection of asset classes and funds, the better it can mitigate losses. Markets tend to work in cycles, and different markets may go up or down at different times. In theory, a diversified portfolio can help your investments so if a few markets take a hit one year, other parts of your portfolio might continue to grow.
So what kind of mix is right for you?
The answer depends on who you are and what you are trying to achieve with your investments. You might decide to invest more money in one class or sector over another based on your financial needs, personality, and timeline.
What are some examples of investment classes or categories?
Here a three examples of major asset classes:
Stocks can be one of the most volatile asset categories. In other words, one year the returns from a stock could be very high, followed by a steep loss the next year. Stock investments can have a lot of potential for large returns, but this is typically true for investors who are willing to ride out several boom and bust cycles, which can take a long period of time.
Bonds are generally considered a safer source of returns than stocks, but their returns are also on average lower. Think of them as a lower risk, lower reward category.
Cash and cash equivalents can include your typical savings account, as well as treasury bills and money market accounts. They’re often considered the safest places to invest, but they’re also known to yield some of the lowest returns over time of the major asset categories.
Keep in mind that each of these categories can consist of an array of companies, industries, and geographic regions. And there’s a whole range of categories beyond these three. Real estate, commodities (like gold, oil, water)… the list goes on. The important thing to know is that each investment category and subcategory may have a different return on investment (ROI), depending on the year.