When it comes to investing, diversification is one of the most common pieces of advice you’ll hear.
But there’s a misconception that being diversified means owning as many different investments as possible.
It doesn’t.
True diversification isn’t about how many investments you own. It’s about how those investments work together.
For example, imagine an investor owns 10 different technology stocks. On paper, that’s 10 different investments. But if those companies are all affected by the same economic factors, industry trends or market conditions, the portfolio may not be as diversified as it appears.
The same thing can happen when an investor owns multiple mutual funds or ETFs that hold many of the same companies. Owning five funds doesn’t necessarily mean you have five distinct sources of diversification.
So, what does effective diversification actually look like?
First, diversify across asset classes.
Stocks and bonds don’t always respond to economic conditions in the same way. Cash and short-term investments can serve a different purpose than long-term growth assets. Depending on your goals, a portfolio may benefit from having different types of investments working together.
Second, diversify within asset classes.
Within stocks, that could mean exposure to different sectors, company sizes and geographic regions. Within bonds, it could mean different maturities, credit qualities and issuers.
The goal isn’t to own everything. It’s to avoid having too much of your financial future depend on any one investment, company, sector or economic outcome.
Third, consider how your investments are correlated.
This is where diversification gets a little more interesting.
Two investments can look completely different on the surface but still move in similar ways. If they tend to rise and fall together, owning both may provide less diversification than you expect.
That’s why simply counting the number of investments in your portfolio isn’t particularly useful.
A portfolio with 20 investments can be less diversified than a portfolio with 10.
The right question isn’t, “How many investments do I own?” It’s “What happens to my portfolio if one part of the market struggles?”
That’s ultimately what diversification is designed to address.
You won’t eliminate investment risk by diversifying. But you can reduce the risk that one investment or one part of the market has an outsized impact on your financial goals. And that’s an important distinction.
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Bautis Financial LLC is a registered investment advisor. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial advisor and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
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