For investors, knowing how to diversify a portfolio can mean the difference between riding out a financial crisis relatively unscathed and panicking as your funds evaporate. Yet, many investors completely misunderstand it, exposing themselves to serious risk and stress. In this post, I’ll clear up some of those misconceptions and show you a few strategies for bypassing the headaches.
Keep in mind that everyone’s situation is unique. Be sure to speak with a financial advisor before settling on any strategy I mention in this post.
Note: This article contains a Wealthsimple affiliate link. If you sign up for their services through that link, I’ll earn a small commission, which helps keep this site as free from ads as possible.
What is diversification?
Diversification is the practice of spreading your money out across several different investments to account for the possibility that some might not perform as well as you hope. While that’s pretty common knowledge, many beginning investors underestimate the complexity of building a diversified portfolio. Specifically, they focus on individual stock diversification, which is just one of many types investors should consider. Let’s take a closer look.
Types of diversification in investing
Note: You wouldn’t necessarily rely on just one of these. Later in this article, I’ll show you how investors often combine the different types of portfolio diversification.
Individual stock diversification
Individual stock diversification involves buying shares in several different companies. The rationale is that you’ll be shielded against any single stock’s turmoil. While that’s true, there are many issues with relying solely on individual stock diversification.
Chief among them is the difficulty involved in picking the right stocks. Even professionals who rely on rigorous analysis struggle in this regard. As an amateur, you’d be lucky to avoid losing lots of money on bad picks, let alone outpacing the growth you would’ve achieved by implementing some other types of diversification.
Market capitalization diversification
The term “market capitalization” refers to a company’s value. For example, Apple has a market capitalization of over $1.5 trillion as of writing. The formula for calculating this is simple. Just take the total number of shares in a company and multiply it by the share price.
Stocks fall into one of three categories when it comes to market capitalization:
These numbers aren’t universally agreed-upon, mind you. You’ll hear different ranges depending on the source and they typically rise over time. I’m just relying on Investopedia’s definitions as of writing.
The rationale behind market capitalization diversification is that each range has its own risk/reward profile. Small-cap stocks are relatively risky bets that could pay off big-time. Mid-caps have achieved some level of stability yet still have lots of potential for growth. Large-caps are among the most reliable companies on earth. They include Apple, Amazon, Disney, and other well-known companies.
Industrial diversification, as you can probably guess, involves spreading your money out across several different sectors. Just as you can’t always guess whether an individual company will do well, concentrating on a single industry can have unpredictable results.
For example, tourism was a booming industry in the 2010s. Its growth in the United States routinely outpaced that of the country’s broader economy. Any investor seeking a reliable sector would’ve at least considered it. Of course, that once-booming industry faced a truly unprecedented collapse in 2020. You would’ve been hurting if your portfolio consisted primarily of tourism-related stocks.
Meanwhile, sectors such as IT performed quite well in early 2020, which hints at a key benefit of industrial diversification. One sector’s solid performance can reduce the impact of another’s slump on your portfolio.
Taking diversification one step further and spreading your money across assets from different countries has many advantages.
Here’s a great example. Can you guess which country had the best performing stock market in 2019? If you live in North America, you’d probably guess the United States. But you’d be wrong – it was Greece. Their key stock index grew by more than 39% while the S&P 500 (which contains 500 of America’s biggest companies) grew by just 28%.
You might also be surprised at which economies are projected to grow the fastest in the coming years. According to Nasdaq.com, they are:
None of this is to say that you shouldn’t invest in the United States. It’s home to the world’s largest economy and produces consistently great investment returns over the long haul. But if you’re looking to maximize growth, you’d be wise to consider broadening your geographical horizons.
Just as individual companies, industries, and countries can differ in economic performance, asset classes don’t always move in unison. An asset class is simply a grouping of investments that share characteristics. The main ones are:
- equities (i.e. stocks)
- fixed income (i.e. bonds)
- commodities (i.e. gold)
- derivatives (i.e. options)
- real estate
- cash (or cash equivalents such as money markets)
You can learn more about these asset classes in the “Common Investments for Beginners” section of this article. The bottom line is that each class has its own risk/reward profile. You can achieve diversification by properly splitting your portfolio between the classes you’ve deemed appropriate for your situation.
As of writing, my portfolio is split into 90% equities and 10% fixed income. Within that split, my investments are divided even further based on some of the aforementioned diversification types. I’ll explain more shortly.
As you probably know, some investments fluctuate in value pretty drastically. A strategy known as dollar-cost averaging can reduce the impact of poorly-timed buys while helping you benefit from any dips. It’s pretty simple. Say you have $10,000 to invest. Instead of dumping it into the market all at once, you could deposit $1,000 every month for 10 months.
Now, there are some very valid criticisms of time diversification. According to Morningstar, the longer you spread your investment out, the less effective time diversification becomes compared to just making a lump-sum deposit. Your odds don’t start out all that great, either; splitting your investment between just two months produces better results only 39% of the time. At 24 months, you’re down to 25%. At the 10-year mark, your rate of success is just 0.46%.
Still, you’ll often hear personal finance experts recommend time diversification because it encourages responsible behavior. Prior to learning about it, many investors try to time the market (i.e. investing all of their money when they think stocks will rise and selling everything when they predict a downturn), which produces disastrous results more often than not. Time diversification can help you realize that success in investing is more about consistency than buying in at exactly the right time – especially when you’re starting out with little money.
Note: Time diversification differs from the other types we’ve discussed so far in that it’s not really a feature of any one investment. You can achieve time diversification in almost any asset by continually investing new money.
Rebalancing: A key part of building a diversified portfolio
Fluctuations in various assets present a challenge when you’re building a diversified portfolio. Some parts of your portfolio (whether you’re diversifying through all or one of the types we discussed in the previous section) will inevitably outperform others, overriding the percentage you originally allotted it.
Say, for example, you decided to split your money evenly (50/50) between the tech and finance industries. Over the following few months, tech performs exceptionally well while finance stays more or less flat. At that point, tech might represent 75% of your portfolio rather than the 50% you originally wanted. (Note: I’m not recommending you split your portfolio in this way; these numbers are purely to demonstrate how important rebalancing is). You would then need to rebalance your portfolio in order to maintain appropriate diversification.
There’s no hard rule as to how often you should rebalance. Some people simply pick an interval (i.e. once per month or quarter) while others rebalance as soon as their portfolio has drifted beyond a certain percentage.
As you might imagine, rebalancing can get pretty cumbersome when you have a portfolio split between numerous assets. Later in this article, I’ll show you a few ways to minimize that headache.
Advantages of diversification
While we’ve touched on a few advantages here and there so far, let’s recap them more succinctly.
A highly concentrated portfolio is at the mercy of whatever assets dominate it. When you’re sufficiently diversified, on the other hand, no one investment has the ability to completely tank your portfolio.
A diversified portfolio tends to be much steadier since various asset classes and regional economies don’t all move at the same pace, even in a global crisis. This is particularly important if you have a less aggressive mindset about investing, which is common with beginners and retirees prioritizing capital preservation rather than growth.
Disadvantages of diversification
No investment strategy is perfect. Here are some of the downsides to diversification. Personally, I think the positives outweigh the negatives but I’ll let you be the judge.
Your gains will be average
Diversification limits the range of movement in your portfolio, making it more likely to follow the market average. This will have you missing out on huge short-term wins, which can be tough if you’re impatient. You’ll have to get used to watching hot stocks triple in value within weeks while your diversified portfolio chugs along at a much slower pace.
Of course, as I’ve mentioned several times so far, it’s not easy to pick winners consistently. Diversification sets you up to win over the long haul rather than scoring a big win followed by several losses.
It’s possible to over-diversify
The rationale here is that there are only so many high-quality assets worth owning out there. Once you’ve diversified yourself sufficiently among them, going any further will just reduce your portfolio’s quality and generate mediocre returns.
This is a surprisingly easy trap to fall into. Experts don’t always agree on what constitutes a high-quality asset and you can often end up being pulled in different directions depending on who you listen to. Many beginning investors even erroneously believe that diversification is just a numbers game and end up cramming their portfolios with all kinds of junk for the sake of it.
How to diversify a portfolio with minimal effort: 5 key strategies
The following methods make it possible to achieve all the aforementioned types of diversification. Remember that you should speak to an advisor before settling on any of these strategies.
1. Exchange-traded funds (ETFs)
ETFs are baskets of assets (stocks, bonds, etc) assembled based on a theme. You’ll pretty much always get individual stock diversification by default. ETFs offering several other types of diversification are very easy to come by as well. For example, an S&P 500 ETF will give you exposure to the industries driving America’s economy while a fund focused on emerging markets will spread your money out internationally.
- Very low fees
- You can get started with little money, which is difficult with many other diversification methods
- Choose from countless ETFs based on your interests and needs
- Individual ETFs rebalance automatically
- It’s easy to double up on assets (thereby reducing diversification) if you unknowingly purchase overlapping ETFs
- You still have to handle portfolio rebalancing on your own when holding multiple ETFs
How to diversify a portfolio with ETFs
Many investors achieve diversification by assembling a portfolio of multiple ETFs. Some investors simplify things even further and choose a single ETF, such as one replicating the S&P 500 (which is what Warren Buffett recommends for most investors) or even the entire global market.
Whichever approach you take to diversification through ETFs, you’ll need to set up a brokerage account, which most major banks offer. Next, research the ETFs out there and purchase one(s) based on your goals and risk tolerance.
2. Mutual funds
Mutual funds are similar to ETFs in that they offer diversified baskets of assets. The primary difference is that mutual funds tend to feature active management. In other words, the fund manager attempts to beat the market by actively picking stocks whereas most ETFs simply track an index. One other difference is that you purchase shares in mutual funds directly from the company offering them rather than on an exchange.
Read more about ETFs and mutual funds here.
- As with ETFs, you can find mutual funds offering exposure to just about every sector, asset class, and geographical region
- Rebalancing is also handled automatically within individual mutual funds
- Fees are typically much higher than with ETFs
- Once again, it’s easy to double-up on investments by unknowingly purchasing shares in multiple overlapping mutual funds
How to diversify a portfolio with mutual funds
Most major banks in Canada and the United States offer their own mutual funds. Look through your bank’s list of offerings and assemble a portfolio that meets your needs. Alternatively, you might find a single mutual fund that offers everything you need, which would save you from having to rebalance a portfolio of multiple funds.
3. Target-date/lifecycle funds
Target-date funds offer a simple, maintenance-free solution for your entire investing timeline. You start off with a fairly aggressive portfolio weighted heavily towards equities (typically national and international ETFs or mutual funds) and then automatically move towards more conservative fixed-income assets as your target date approaches. The logic is that you can afford to be aggressive in your younger years because you have time to recoup potential losses, which isn’t the case as you get older.
People typically use target-date funds (which you’ll also hear referred to as lifecycle funds) to save for retirement or some other long-term goal.
- Enjoy truly hands-free diversification; a portfolio manager does all the work
- Many options to choose from at large financial institutions like Vanguard
- Fees can be on the higher side compared to other diversification methods
- You can’t customize your individual holdings
How to diversify a portfolio with target-date funds
Getting started is as simple as choosing a target-date fund that meets your needs and investment timeline. Vanguard is among the most famous providers of these funds, which also include TIAA, BlackRock, and John Hancock Investment Management. You’ll need to open up an account with your provider of choice then make a deposit and perhaps set up regular subsequent contributions.
That’s all there is to it! Target-date funds are a really simple solution for achieving all types of diversification.
Robo-advisors are algorithms that collect information about your financial situation before assembling and maintaining an appropriate portfolio for you. This is my preferred diversification strategy because it allows for customization while still being mostly hands-off.
- Greater customization than you’ll find with other types of funds (including ETFs and target-date)
- Automatic portfolio rebalancing
- Low/no-minimum starting balances
- Little work required on your part
- Fees are on the higher side
- The relative lack of human interaction might be strange for investors accustomed to traditional financial advisors
How to diversify a portfolio with a robo-advisor
All you have to do is open up an account with your robo-advisor of choice, provide some information about your financial situation, and make your first deposit. The algorithm will then diversify your money, typically in various ETFs and bonds.
My preferred robo-advisor is Wealthsimple. I put the bulk of my money in their most aggressive portfolio, which holds 90% equities and 10% fixed income. On the equities side, my money is diversified geographically, with special weight given to Canadian and American ETFs. With that setup, I’m able to achieve each type of diversification we previously discussed with practically no effort on my part.
I switched to Wealthsimple in 2019 after managing my own ETF portfolio for a couple of years. I found it difficult to stay on top of rebalancing and conduct the seemingly endless amounts of research required to maintain confidence in my portfolio. I’m more than happy to pay the modest annual fees (0.4% over $100,000 in deposits; 0.5% for anything under) for the peace of mind. I’ve been really happy with the performance, too.
5. Conventional investment advisors
Funds and robo-advisors are great in that they have allowed ordinary people to access investment vehicles that were previously only available through conventional advisors. That doesn’t mean advisors (you know, the suit-wearing stiffs that companies like Questrade love to mock in commercials) have gone the way of the dinosaurs, though. Many people still enjoy their guidance when navigating the complex world of investing.
- Have a professional handle asset selection and choosing the right types of diversification for you
- Enjoy the personal touch when evaluating your financial progress (something often missing from other strategies, including robo-advisors)
- Higher fees and, in many cases, minimum balances
- Lack of control over your portfolio
- Advisors sometimes have restrictions on what assets they can actually purchase for you
Let’s unpack that last point in the “Cons” section. Say you choose an advisor at a major bank that also offers its own investment products such as mutual and index funds.
Generally, the advisor is going to put your money in those assets rather than directing it outside of their own firm to a competitor. This could have negative effects on your portfolio if the competitor’s assets are a better fit.
This isn’t just an issue with major banks, though. Even standalone advisors occasionally have incentives to sell you assets from one company over another. However, there are advisors out there that don’t work under these limitations and will choose the best asset for you regardless of who offers it. You just need to ask the right questions when interviewing candidates.
How to diversify a portfolio with an advisor
Your first step should be to find an advisor that you believe can push you towards your financial goals. You should interview more than one advisor, inquiring about their qualifications, number of clients, performance, communication frequency, references, and – very important – how they make money. The latter will help you understand the advisor’s motives as discussed in the previous paragraph.
One last crucial step is to ensure the advisor is actually registered. If you’re in the United States, conduct a search of the Securities and Exchange Commission (SEC) database here. If you’re in Canada, conduct a search of the federal regulator database here.
Once you’ve chosen an advisor, the process is pretty simple. You’ll complete their onboarding process and then start on a plan towards your goals.
Diversification doesn’t have to be difficult
I hope this post has done a good job of showing you that portfolio diversification doesn’t have to be a nightmare. Choosing individual stocks and hoping for the best can yield results that are lackluster at best and disastrous at worst. By instead relying on the types of diversification we discussed in this post – and the methods for achieving them – you can have a much easier time and enjoy more reliable financial progress.
To recap, the types of diversification are:
- individual stock
- market capitalization
- asset allocation
Five strategies you can use to achieve these types of diversification are:
- Mutual funds
- Target-date funds
- Conventional investment advisors
Remember, you should always speak with an advisor before settling on any strategy.
Frequently asked questions
A well-diversified portfolio is one in which the influence of any single asset is carefully controlled. This reduces risk and has generally produced better long-term results throughout history.
Many successful investors shy away from choosing individual stocks and rather diversify through various asset classes and industries. It’s not hard to see why when you consider that you generally need 20 to 30 separate stocks to achieve diversification in the U.S. market. That number is much greater in economies where stocks are more correlated to one another. This can quickly turn into a nightmare when you consider rebalancing and transaction fees. Why not own hundreds (potentially thousands) of companies through a portfolio of ETFs instead?
A balanced portfolio will generally contain a mix of equities, fixed income, and cash offering exposure to domestic and international markets.
Over-diversification is certainly possible. You can choose too many assets and either inadvertently double-up on some investments or dilute your portfolio’s focus, limiting its gains. Ideally, you want to choose the best assets within each type of diversification you’ve identified and ignore ones that aren’t suitable for your portfolio. This is easier said than done, which is why it’s often beneficial to rely on at least some degree of expert analysis in the form of ETFs, robo-advisors, and other investment vehicles rather than choosing your own individual stocks.