Why Portfolio Diversification Matters & How to do it

What is portfolio diversification? Why does it matter? 

A diversified portfolio is a collection of different investments that combine to reduce an investor's overall risk profile. Diversification includes owning stocks from several different industries, countries, and risk profiles, as well as other investments such as bonds, commodities, and real estate. These various assets work together to reduce an investor's risk of a permanent loss of capital and their portfolio's overall volatility. In exchange, the returns from a diversified portfolio tend to be lower than what an investor might earn if they were able to pick a single winning stock. 

How to build a diversified portfolio

A diversified portfolio should have a broad mix of investments. For years, many financial advisors recommended building a 60/40 portfolio, allocating 60% of capital to stocks and 40% to fixed-income investments such as bonds. Meanwhile, others have argued for more stock exposure, especially for younger investors.  

One of the keys to a diversified portfolio is owning a wide variety of different stocks. That means holding a mix of tech stocks, energy stocks, and healthcare stocks, as well as some from other industries. An investor doesn't need exposure to every sector but should focus on holding a wide variety of high-quality companies. Further, investors should consider large-cap stocks, small-cap stocks, dividend stocks, growth stocks, and value stocks. 

In addition to owning a diversified stock portfolio, investors should also consider holding some non-correlated investments (e.g., those whose prices don't ebb and flow with the daily gyrations of stock market indexes). Non-stock diversification options include bonds, bank certificates of deposit (CDs), gold, cryptocurrencies, and real estate.

Three tips for building a diversified portfolio 

Building a diversified portfolio can seem like a daunting task since there are so many investment options. Here are three tips to make it easy for beginners to diversify.  

1. Buy at least 25 stocks across various industries (or buy an index fund)

One of the quickest ways to build a diversified portfolio is to invest in several stocks. A good rule of thumb is to own at least 25 different companies.

However, it's important that they also be from a variety of industries. Although it might be tempting to purchase shares of a dozen well-known tech giants and call it a day, that's not proper diversification. If tech spending takes a hit due to an economic slowdown or new government regulations, all those companies' shares could decline in unison. Investors should make sure they spread their investment dollars around several industries.

One quick way to do that for those who don't have the time to research stocks is to buy an index fund. For example, an S&P 500 index fund will aim to match the S&P 500's performance. The benefit of index funds is that they take a lot of guesswork out of investing while offering instant diversification. For example, with an S&P 500 index fund, you're buying shares of a single fund that gives you exposure to 500 of the largest public U.S. companies.

Another great thing about index funds is that their fees -- known as expense ratios -- are very low. That's because, with the best index funds, you're not paying for the expertise of a fund manager who's going to research and hand-pick investments for you.

Diversification reduces the risk of cracking your nest egg

Diversification is about tradeoffs. It reduces an investor's exposure to a single stock, industry, or investment option. While that can potentially cut into an investor's return potential, it also reduces volatility and, more importantly, the risk of a bad outcome. Investors should take diversification seriously. Otherwise, they're taking a big gamble that an outsized bet won't spoil their hopes of expanding their nest egg to support them in their golden years.