By Benjamin Roure L'Hermitte
Diversification means spreading your money across many investments so that a loss on one weighs little on the whole: not putting all your eggs in one basket. A diversified portfolio mixes securities, sectors, countries and asset classes that do not react the same way to the same events. This guide explains what diversification means, what it protects you from and what it does not, how to choose an asset allocation and why to rebalance it.
- Diversify: spread your money across many different investments so that one falling does not take everything down.
- In 2008, US stocks lost 37% while bonds gained 5.2%: a 60/40 portfolio lost about 20%.
- In 2022, both fell together, −18.1% and −13.0%: diversification reduces risk, it does not remove it.
- Rebalancing once a year brings the portfolio back to its chosen allocation, selling what rose to buy what fell.
Nobody knows which investment will do best next year. Diversification starts from that fact: instead of betting on a winner, you hold a little of everything, and accept never having the best possible return in exchange for avoiding the worst.
The examples in this guide use US indexes, the S&P 500 and the Bloomberg US Aggregate. The principle applies everywhere. For the basics, our guide what is investing covers the main types of investments.
TL;DRDiversification means spreading money across many securities, sectors, countries and asset classes so that a single loss weighs little. It almost eliminates the risk specific to one company, but not market risk: in 2022, stocks and bonds fell together. Asset allocation sets the share of each class according to your time horizon and risk tolerance; rebalancing, once a year or past a set drift, keeps it in place.
What does diversification mean?
In finance, to diversify means holding a variety of investments rather than just one. A diversified portfolio contains many securities from different sectors and countries, and several asset classes: stocks, bonds, cash, sometimes real estate. The idea is that these investments do not all rise or fall at the same time.
Diversification works at several levels, from the simplest to the broadest.
| Level | What you spread | Example |
|---|---|---|
| Within an asset class | Many securities instead of one | An index fund of 500 companies instead of a single stock |
| Across sectors and countries | Technology, health care, energy, financials; US, Europe, emerging markets | An international fund alongside a US fund |
| Across asset classes | Stocks, bonds, cash, real estate | 60% stocks and 40% bonds |
| Over time | Regular purchases instead of a lump sum | A contribution every month |
What diversification protects you from
An investment's risk has two parts. Specific risk comes from the company: fraud, a failed product, bankruptcy. Market risk hits all securities at once: a recession, rising interest rates. Diversification all but removes the first. With a single stock, a bankruptcy costs 100%; in a portfolio of 50 equally weighted stocks, it costs 2%.
Market risk remains: when the whole market falls, a diversified stock portfolio falls too. That is why investors mix different asset classes, including bonds, which have often, but not always, behaved differently from stocks.
Does diversification always work?
Two recent years show what it does and what it does not do.
| Year | US stocks (S&P 500) | US bonds (Bloomberg US Aggregate) | 60/40 portfolio, approximate |
|---|---|---|---|
| 2008 | −37.0% | +5.2% | about −20% |
| 2022 | −18.1% | −13.0% | about −16% |
Annual total returns; the 60/40 figure uses fixed weights over the year. In 2008, bonds cushioned much of the fall in stocks. In 2022, a rapid rise in interest rates pushed both down at once, and the bond index had its worst year since it began in 1976. Diversification reduces losses on average; it does not guarantee that one part rises when another falls.
Asset allocation: how much in each class
Asset allocation is the share of each asset class in your portfolio. It is the decision that weighs most on both return and volatility. Two questions guide it: when will you need the money, and how large a decline can you sit through without selling in a panic? The longer the horizon, the higher the share of stocks can be; as the date approaches, bonds and cash take a bigger share.
Asset allocation funds, including target-date funds, do this work for you: they hold a mix of stocks and bonds and make it more conservative as the chosen date, often retirement, approaches. Their fees vary, and that is the first thing to compare.
Rebalancing your portfolio
Over time, the asset classes that rise take up more room and the allocation drifts. Example: $100,000 invested 60% in stocks and 40% in bonds. Stocks gain 20% and bonds 2%: the portfolio is worth $112,800, of which $72,000 in stocks, or 63.8%. To get back to 60%, you sell $4,320 of stocks and buy the same amount of bonds.
| Stocks | Bonds | Total | |
|---|---|---|---|
| At the start | $60,000 (60%) | $40,000 (40%) | $100,000 |
| A year later | $72,000 (63.8%) | $40,800 (36.2%) | $112,800 |
| After rebalancing | $67,680 (60%) | $45,120 (40%) | $112,800 |
Rebalancing means selling what has risen and buying what has fallen, against instinct. Once a year, or when an asset class drifts more than five points from its target, is usually enough. In a taxable account, sales can trigger capital gains tax: directing new contributions to the lagging class avoids having to sell.
How to build a diversified portfolio simply
- Set your time horizon and the decline you can tolerate, then choose an allocation, for example a share of stocks and a share of bonds.
- Cover each class with a broad, low-cost fund: a stock index fund, possibly an international fund, a bond fund. See index funds vs ETFs vs mutual funds.
- Avoid overlap: several funds holding the same large companies do not add diversification.
- Cap the weight of any single stock, including your employer's shares in a 401(k).
- Rebalance once a year and keep the allocation through declines.
For where each kind of money belongs, from emergency savings to retirement accounts, see our guide on where to invest money.
Frequently asked questions
What does diversification mean?
Spreading money across many different investments, securities, sectors, countries and asset classes, so that a loss on one weighs little on the whole.
What is a diversified portfolio?
A portfolio holding many securities from varied sectors and countries, and several asset classes such as stocks, bonds and cash.
Does diversification eliminate risk?
No. It nearly removes the risk specific to one company, but not market risk: in 2022, US stocks and bonds fell together.
How many funds do you need to be diversified?
Few: a broad stock index fund and a bond fund are often enough. Adding funds that hold the same securities does not add diversification.
What is asset allocation?
The share of each asset class in a portfolio, set according to time horizon and risk tolerance. It is the decision that weighs most on return and volatility.
How often should you rebalance?
Once a year, or when an asset class drifts more than five points from its target, is usually enough. Directing new contributions to the lagging class avoids taxable sales.