What is Diversification and Why You Should Use it For Your Portfolio

Quick facts

• Diversification is a risk management technique that spreads investments around to limit exposure to any one type of asset.

• Diversifying across and within asset classes can reduce your portfolio's volatility and enhance potential long-term returns over time.

• Pooled investments like mutual funds, index funds and exchange-traded funds can provide instant diversification.

• A financial advisor can help you implement a diversification strategy to balance high-risk and low-risk investments to suit your goals and risk tolerance.

Diversification and performance

A concentrated investment portfolio has a substantial portion of the total investment allocated to a small number of assets, sectors or geographic regions. This strategy often focuses heavily on specific stocks, aiming for high returns from these concentrated bets. While this approach may yield significant gains, the portfolio's value can suffer greatly if a single investment performs poorly.

While there are times when concentration wins out, diversified portfolios have outperformed concentrated ones during most years since 1926.¹ The 60/40 portfolio – a diversified mix of 60% stocks and 40% bonds – reflects a typical "moderate" investor's asset allocation. Of course, the heavier the stock allocation, the greater the potential upside and higher the risk (and vice versa). Data shows how the average annual returns from 1970 to 2024 stack up at various risk levels:²

• Aggressive (95% stocks): 10.3%

• Moderately aggressive (80% stocks): 9.9%

• Moderate (60% stocks): 9.3%

• Moderately conservative (40% stocks): 8.4%

• Conservative (20% stocks): 7.1%

Generally, concentrated portfolios are best suited for experienced investors willing to accept higher risks for potentially greater rewards. At the same time, diversified portfolios are often the better choice for investors seeking consistent long-term growth while being able to sleep at night.

How do I diversify my portfolio?

Building a diversified portfolio can be a complex, if not daunting, process. It involves carefully selecting investments from various asset classes, sectors and geographic regions to optimize returns while minimizing risk. Combining low-correlation assets (those that tend to behave differently) helps ensure you diversify effectively and avoid over-concentration in one area. Ongoing portfolio rebalancing to maintain allocations adds to the complexity, as does the challenge of managing costs and tax implications.

While there are numerous ways to achieve a well-balanced and diversified portfolio, the best approach depends on your risk tolerance, time horizon and financial goals. A good starting point for many investors is to invest in pooled investments like index funds, mutual funds and exchange-traded funds (ETFs). These funds can be an affordable way to access built-in diversification across many securities that would otherwise be difficult or expensive to invest in individually.

Asset class diversification

The primary way to diversify a portfolio is to invest in a mix of common asset classes, including:

• Stocks

• Bonds (fixed income)

• Cash and cash equivalents

• Real estate and alternative assets

These asset classes have varying risk levels and tend to generate different returns. For example, stocks are generally considered riskier than bonds but offer an opportunity for higher long-term returns. On the other hand, bonds can provide a level of income stability, but they generally offer lower returns and can be sensitive to interest rate changes. Holding a mix of different assets increases the likelihood that some of your investments will perform well even if others lose value – reducing risk and increasing stability in your portfolio overall.

Still, diversifying across asset classes is just a starting point. To build a well-diversified and balanced portfolio, you'll also need to diversify within those classes. With bonds, diversification increases when you choose different terms, credit ratings and issuers, such as corporations, state and local governments or the federal government (think Treasuries). With stocks, diversification increases when you invest in companies in different geographic regions, sectors and sizes.

Geographic diversification

Domestic markets provide familiarity and potentially less currency risk, while international investments offer opportunities in varied industries, growing economies and different market cycles. Investing in both domestic and international markets helps reduce risk by spreading exposure across a broader set of economic environments, potentially increasing your portfolio's stability.

Sector diversification

MSCI’s Global Industry Classification Standard (GICS) divides every publicly traded company into 11 sectors:³

• Communication services

• Consumer discretionary

• Consumer staples

• Energy

• Financials

• Healthcare

• Industrials

• Information technology

• Materials

• Real estate

• Utilities

Investing across various sectors can reduce risk by minimizing the impact of any single industry's poor performance. Sectors often perform differently based on economic cycles, so diversification ensures that a strong performance in one sector may help offset weakness in another. This approach provides exposure to a broader range of opportunities and leverages the strengths of each sector, increasing stability and potentially increasing long-term growth.

Size diversification

Companies of various market capitalizations behave differently due to their unique characteristics. Large-caps may deliver stability and consistent performance, mid-caps may offer growth with moderate risk, and small-caps may provide high growth potential with more volatility. Spreading investments across these categories ensures exposure to different growth stages and market dynamics, reducing reliance on a single capitalization type and enhancing long-term performance.

Growth vs. value stocks

Diversifying between growth and value stocks can help balance your portfolio's risk and return profile, as the two styles often perform differently in various market conditions.

• Growth stocks have higher upside potential but are inherently more risky. These companies are expected to grow faster than the market average, so their stock prices are high relative to their profits. Because growth is the priority, earnings are usually reinvested in the company rather than paying dividends.

• Value stocks have lower growth expectations but tend to be safer investments. These companies are undervalued relative to their fundamentals, so their share prices may be a bargain. Even if prices don't rise, investors usually benefit from regular dividend payments.

Regularly review and adjust your portfolio

Building a diversified portfolio isn't a set-it-and-forget-it task. Instead, it's essential to review and adjust your portfolio regularly to ensure you maintain proper diversification levels, particularly during periods of market volatility. Market movements can cause asset allocations to drift from their original targets over time, increasing risk or reducing growth potential. Rebalancing restores your intended mix of assets, keeping your portfolio aligned with your risk tolerance, time horizon and financial goals.

Consult with a financial advisor

Many investors don't have the time, expertise or inclination to build and maintain a diversified portfolio. A financial advisor can help by creating a bespoke diversification strategy suited to your risk tolerance, time horizon and financial goals. They can also adjust the strategy as market conditions – and your personal circumstances – change, ensuring your portfolio stays aligned with your objectives for long-term success.

Bottom line

Diversification reduces risk by spreading investments across various assets, sectors and regions. This approach minimizes investment risk, protects against market volatility and boosts the potential for steady growth over time, allowing you to sleep well and live well. Consider working with a financial advisor who can help you develop a comprehensive investment plan that includes proper diversification strategies, giving you more time (and potentially more money) to spend on the things that matter most.

At Conway Wealth, we know going at it alone is not an easy feat.

For more information on finding the right financial advisor that can address your unique needs, feel free to reach out directly to the Conway Wealth team by emailing info@conwaywealthgroup.com or calling 973.285.3640.

Investment advisory and financial planning services offered through Summit Financial, LLC, an SEC Registered Investment Adviser, doing business as Conway Wealth Group (4 Campus Drive, Parsippany NJ 07054. Tel.973-285-3600). 7441363.1

1. Kenneth R. French Data Library from the Tuck Dartmouth School of Business per SPDR Americas Research Calculations as of July 21, 2024, from data between 1926-2024. Past performance is not a reliable indicator of future results.
2. Morningstar, Inc. Data from 01/01/1970 to 09/30/2024.
3. MSCI, “The Global Industry Classification Standard (GICS®)” (2024)

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