Diversifying Your Portfolio

Rather than trying to pick potential winners and avoid potential losers, diversification calls for owning a piece of the entire market to increase your chances of long-term success. As the saying goes, "If you can't find the needle, buy the haystack."

Diversification helps lower your overall investment risk by tapping into a concept known as correlation. Correlation is used to show how different investments move compared with one another. When you combine investments that don't move in the same way, your portfolio has low correlation, which can protect against extreme declines. For example, when stock prices fall, bonds typically (but not always) go up. By owning both, you can reduce big swings in your portfolio's value.

So how can you diversify your portfolio? True diversification involves owning stocks from various industries, countries, and risk profiles. It also means investing in other asset classes beyond equities, such as bonds, commodities, and real estate, whose performance isn't usually in sync with stocks during different market environments. These assets work together to reduce a portfolio's overall risk and volatility. 

Diversification applies to both the stock and bond portions of a portfolio. On the stock side, it means owning shares of U.S. and international companies of different sizes and in different sectors. Bond funds are composed of government bonds, corporate bonds, and municipal bonds, among others.

Having a balance of lower-risk assets like bonds and higher-risk assets like stocks allows a portfolio to grow while providing a cushion against volatility. While stocks offer higher expected returns over the long run, they can experience substantial short-term swings. High-quality bonds, on the other hand, tend to generate lower returns but may provide stability. A diversified portfolio reduces overall risk while still allowing for long-term growth potential. Of course, a diversified portfolio approach may underperform relative to a winning investment, but it may provide stability and can help you sleep at night.

Market factors have changed the dynamics of bond investing and how investors should approach using bonds for portfolio diversification. Higher rates in recent years have created short-term challenges for existing bondholders.

While the bond market has faced headwinds, owning fixed income investments is still an important part of portfolio diversification because these assets may offer stability and can reduce volatility. Bonds generally offer fairly reliable returns and are better suited for risk-averse investors.

We've all heard stories about the great-grandparent who bought a share of Coca-Cola stock in the 1920s and went on to create generations of multimillionaires. But what about the great-grandparent who bought the stock of a company that went bankrupt or fell victim to new technology or rising competition? For every wildly successful investment, there are many more duds that fizzle out. It's just as easy to pick a loser as it is to pick a winner. That's why diversification is so important. It allows you to simply be in the market without worrying about finding winners and losers.

Diversification helps you reduce the risk of investing everything in a company that goes under by buying hundreds or thousands of securities at a time. In general, diversification is more about risk management than maximizing returns, aiming to reduce the volatility and potential losses in a portfolio rather than hindering or boosting returns.

"Sounds great," you might say to yourself, "but where am I going to get the money for thousands of investments and the time to research them?" Luckily, that's exactly what mutual funds and ETFs are designed for. As an investor, you can simply buy shares of the fund itself and, in turn, gain instant diversification because both investments are professionally managed collections (or "baskets") of individual stocks or bonds.

Find out more about the benefits of buying mutual funds and ETFs

Building a diversified portfolio involves spreading your investments across different asset classes, sectors, and geographies and using different investment styles. Keep these things in mind as you create a diversified portfolio:

Asset allocation:

A diversified portfolio starts with the understanding that you'll have a variety of asset classes. The percentage you invest in each asset class depends on your risk tolerance, time horizon, and goals. Here are three commonly used allocation strategies that reflect varying levels of risk and return:

• Aggressive – 80% stocks/20% bonds
• Moderate – 60% stocks/40% bonds
• Conservative – 40% stocks/60% bonds

A higher stock allocation may provide more growth potential but also greater volatility, while a higher allocation of bonds may increase stability but may dampen long-term returns.

Diversify within asset classes

• Market capitalization. Include large-, mid-, and small-cap companies.
• Sectors. Spread your investments across various industries like technology, health care, energy, and financials.
• Geographic regions. Invest in both domestic and international markets, including developed and emerging economies.
• Investment styles. Balance between growth stocks and value stocks.

For bonds, consider a mix of Treasury, corporate, and municipal bonds.

This multifaceted approach to diversification within each asset class helps ensure your portfolio isn't overly dependent on any single performance factor. It can provide more consistent returns across different market conditions and economic cycles.

Alternative investments.

Adding assets like real estate or commodities can further diversify your portfolio.

Mutual funds and ETFs.

Both funds give you access to a wide variety of U.S. and international stocks and bonds. You can invest broadly (e.g., a total market fund) or narrowly (e.g., a high-dividend stock fund or a sector fund)—or anywhere in between.

Automation.

Digital platforms can automatically build and manage a diversified portfolio based on your goals and risk profile.

Vanguard Digital Advisor among lowest-cost robo-advisors

Building an appropriately diversified portfolio is only the first step. Over time, market movements will cause your asset allocation—the percentage of your money invested in different types of investments—to drift. For example, if stocks have a strong run, the equity portion of your portfolio may grow larger than forecasted.

To maintain your preferred asset allocation, it's important to rebalance periodically by shifting some of your portfolio's earnings into other parts of your portfolio that may not have fared as well. This process of rebalancing your portfolio can help you practice the time-honored "buy low, sell high" strategy, controlling risks and keeping you aligned to your long-term plan.

Financial advisors recommend reviewing your portfolio annually and rebalancing when an asset class drifts more than 5%–10% from its target. For example, you might intend to allocate 60% of your portfolio to stocks, but if stocks are performing well, you could end up drifting closer to a 75% allocation. Shifting assets to maintain your intended allocation ensures your portfolio continues to mirror your risk tolerance and goals.