What is diversification?

You may have heard about the importance of a diversified investment portfolio. But what does that really mean?

Diversification definition

Diversification refers to spreading your money across a variety of different investments. Doing so can be a potentially effective way to lower the volatility of returns your portfolio earns, thereby reducing risk. The following are some key ways to achieve diversification.

Benefits of diversification

Diversification can serve to support risk and return goals by smoothing out the variability of the return stream. In any given time period, one type of security or asset class will do better than others, but predicting the winner isn’t easy.

Different securities and asset classes may do better or worse in certain economic environments, such as in a recession or period of high inflation. Individual companies can also be affected by both internal fiscal management and market forces. Combining a variety of investments like stocks, bonds, cash and alternative assets can potentially protect you from experiencing a significant drop in the value of your whole portfolio should any one investment perform poorly.

Historically, well-diversified portfolios have offered moderated risk by dampening the variability of returns compared to more concentrated portfolios. You won’t necessarily attain the highest returns this way, but you are more likely to avoid catastrophic lows or intolerable volatility. However, diversification does not guarantee a profit or protect against loss.

The degree to which diversification dials back the risk in your portfolio will largely be driven by the percentage allocated to higher-risk asset classes like stocks. Over time, taking on the risk of owning stocks is typically rewarded by relatively higher expected returns. However, past market performance is no guarantee of future results. Conversely, comparably safe investments – as defined by characteristically low volatility, like cash – historically have provided some of the lowest returns of all asset classes.

Investment vehicles that can offer the benefit of diversification

Pooled investments like mutual funds and exchange-traded funds (ETFs) may offer a way to achieve a diversified portfolio. In both cases, a single purchase can provide exposure to numerous securities.

Both ETFs and mutual funds aggregate pools of money from many investors and use the funds to buy a basket of securities. This can allow you to attain greater diversification benefits for the same dollar amount than if you were to buy individual positions yourself.

Avoid over-diversifying

A carefully constructed portfolio of diversified holdings can help you work toward your financial goals without the undue risk that can come with a concentrated portfolio. It’s important to ensure holdings are materially different from one another. For example, two U.S. stock funds with similar securities will likely offer scant diversification benefits, whereas pairing a stock and a bond fund may more effectively limit risk in your portfolio.

It’s also important to note that if your portfolio has too many holdings the burden of monitoring it may make it difficult to truly assess the efficacy of your asset allocation. As always, the way you allocate your assets should reflect your goals and time horizon for return as well as the level of risk you find acceptable.

Don’t know where to start? A J.P. Morgan advisor can help you find a balance of diversification that suits your risk profile, time horizon and goals.

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