“Don’t put all your eggs in one basket.”
You’ve probably heard this growing up, but what does it mean, and how can it teach you about diversification?
A farmer piles all the eggs he collects in the morning into a single basket. If the basket is dropped, he loses all his eggs in one fell swoop.
The same goes for your investments.
If you put your entire net worth into Peloton (PTON) stock in 2021, you might have cracked open your nest egg when it plummeted 90% in 2022.
Diversification can help you create a more stable investment approach, while enjoying the growth of different types of investments.
Let’s go over the basics of investment diversification, and give you a few tips on how to create a more diversified portfolio.
What is investment diversification?
When talking about investments, diversification refers to the process of dividing your money between different assets in order to reduce risk and volatility.
This could mean splitting up your money between stocks, bonds, real estate, gold, crypto, or other assets, with the goal of taking advantage of the growth in each asset class, but also spreading your risk as well. Diversification is a smart way to invest, as you reduce the risk of putting all your eggs in one basket.
For example, if you decided to go “all-in” on Shopify in 2020, you would have been rewarded with a massive 4x return on your investment within a year, only to see it crash down by nearly 80% the following year, dropping below the original price you purchased it at.
But if instead, you purchased multiple stocks, bonds, and other assets, you may not have seen the short-term 4x in value, but you also may not have seen the 80% loss that followed — and could still be in profit on your portfolio.
There are several ways to diversify your investments. Here are seven tips on how to do it — as well as what to consider when evaluating your investment decisions.
1. Learn about risk
Losing money is no fun, but investing always involves risk, which includes the risk of loss. Learning about the types of risks involved with your investment choices allows you to become a smarter (and less stressed-out) investor. And spreading your risk across different assets can help you balance your portfolio and lower the overall volatility of your investments.
Here are a few types of risk to be aware of as you build your investment portfolio:
- Business risk. When investing in individual stocks, it is important to research how a business operates, how it makes money, and the risks associated with that particular business. This can include management changes, upcoming payoffs, debt-to-income ratio, or other factors that might affect the share price.
- Market risk. When investing in assets such as stock or real estate, it’s important to understand how the overall market sentiment can affect the price of those assets.
- Default risk. For investing in individual businesses or stocks, understanding the debt obligations is important, especially if the company has a high percentage of operating costs going to service their debts. The risk of defaulting on those debts can affect share prices.
- Inflation risk. In an inflationary environment, stocks can drop in price, but so can other assets. It’s important to understand how your investments will perform if inflation rises faster than usual.
- Interest rate risk. Certain investments (such as bonds) can drop in price if there is an increase in overall interest rates by the Federal Reserve.
2. Create an asset allocation
When you invest, you are purchasing assets that generate income or go up in value over time. How you allocate your funds toward different types of investments is called asset allocation.
When investing in stocks, one of the best ways to diversify is to split up your investments between assets that are in different market sectors (such as technology, agriculture, real estate, healthcare, etc.). This builds diversification within your equities portfolio.
To take it a step further, splitting your portfolio into different types of investments can help diversify between assets that aren’t correlated, such as stocks, bonds, U.S. treasuries, physical real estate, commodities (gold, etc.), and even angel investments in businesses. That way, when one asset class drops in value, it doesn’t necessarily mean the others will.
In fact, there are some asset classes that are inversely correlated, meaning that if the price drops in one asset class, the other actually goes up in value. This has typically been the case with stocks and bonds, though interest rates going up (as was the case in 2022) can affect both.
To properly diversify your investments with asset allocation, it’s important to think of your investments as a pie, and each asset class will have a slice of that pie, depending on your risk tolerance, investment goals, and investing timelines.
This pie chart of a sample asset allocation can help you visualize how your assets could be split up:
3. Invest in index funds
While picking and choosing individual companies to invest in takes a ton of research and understanding of business models and financials, investing in index funds makes it easy by allowing you to own hundreds (or thousands) of company stocks within one single investment.
Not only that, but index funds typically invest more in larger, more established companies, while still holding smaller, growing companies — giving you the best of both worlds with less risk.
Index funds are a type of mutual fund or exchange-traded fund (ETF) that hold a variety of individual stocks, bonds, and other assets, and typically follow a market index, such as the S&P 500 index. These funds are typically market-cap weighted, holding more investments in companies that have the highest market capitalization.
Index funds give you automatic diversification, as you can own an entire market sector within a single investment. Some of the most popular funds even own every publicly traded company within a market, such as the total U.S. stock market.
You can own several types of index funds, such as stock market funds, bond market funds, real estate/REIT funds, or balanced funds that own a mix of each. And because index funds are passively managed, the fees are typically much lower than their actively managed counterparts.
Oh, and they outperform almost every hedge fund and actively managed fund over a long period of time. Even Warren Buffet agrees.
So, if you’re looking to diversify your portfolio the easy way, buying index funds according to your asset allocation is the way to go.
4. Invest outside of the U.S.
While the U.S. economy is one of the largest in the world, and the U.S. stock market has averaged nearly 10% returns over the past 100 years, you can further diversify your investments by putting some money toward companies and assets that are outside the U.S.
One of the easiest ways to do this is with an international index fund that holds some of the top companies and assets in foreign markets. This includes international stock market funds, as well as international bond market funds.
Remember, there are many top-tier companies that are headquartered outside of the U.S., such as:
- And many more
Investing outside of the U.S. can help protect your portfolio from U.S.-specific downturns, as well as capture the growth of emerging economies. It also gives you an uncorrelated asset in your portfolio, offsetting some of the risk of investing only in the U.S.
Another form of international investing can be purchasing real estate in another country, to be used as a rental property, or some other income-producing activity. While regulations can vary from country to country, this can be a way to diversify your real estate holdings into other markets.
5. Don’t forget real estate
While many investors will solely focus on investing in the stock or bond markets, holding real estate is a great way to own well-performing assets that are typically uncorrelated with the stock market.
Real estate is a solid long-term investment, and there are many ways to invest in it:
Investing in real estate investment trusts (REITs) is a passive way to own real estate without having to purchase a property or manage it. REITs have become popular over the past decade and allow investors to own a portion of a real estate project, which can include commercial or residential real estate.
REITs can be bought and sold from most online brokers and make it easy to own a portion of several real estate properties.
Crowdfunded real estate
Crowdfunding allows you to invest directly into a real estate project, pooling together funds from investors. Crowdfunding offers potentially high returns, but also may come with a high minimum investment.
Crowdfunding used to only be available to private investors but was opened to regular investors in the Jumpstart Our Business Startups Act in 2016.
Airbnb has opened up the vacation rental market to regular investors, allowing you to rent your property like a hotel. You can put your property up on Airbnb, VRBO, or any other short-term rental site, and charge a higher rate for vacation stays. (However, note that if you’re a renter, your city or landlord may have rules about subletting for more than you pay in rent).
From tiny homes to mansions, almost any type of home can be turned into a vacation property and net you great returns if managed properly.
Read more: Is being an Airbnb host worth it?
Long-term rental properties have been a fantastic asset class for hundreds of years, and even Andrew Carnegie (once the world’s richest man) has quipped that nearly 90% of the world’s millionaires have made their fortune in real estate.
Buying a single-family home, duplex, or multifamily property can bring in monthly income, as well as benefit from appreciation over time. It does require a more hands-on approach, though most of the management and maintenance can be hired out.
6. Use multiple investment account types
Diversification of your investment account types is just as important as the assets you hold. This is because there are different tax benefits to each account, and strategically diversifying your holdings between investment accounts can help save you a lot of money in taxes.
Here are a few investment accounts to consider when you are building a diversified portfolio:
Workplace retirement account
The 401(k) is a tax-advantaged retirement account that may be available at your workplace. This account makes it easy to invest directly from your paycheck, as well as allows you to deduct investments from your taxable income for the year.
Some jobs offer variations of this, including the TSP, 403(b), 457(b), or other retirement plan.
Individual retirement account (IRA)
The IRA is a popular retirement account that is not attached to your job, allowing you to choose your brokerage and investments within the plan. This can be opened through an online brokerage for free, or through a licensed investment advisor if you prefer professional management of your investments.
There are tax advantages, too, with traditional IRA contributions lowering your taxable income now, and Roth IRA contributions can be withdrawn tax-free at retirement.
Read more: How to open your first IRA
Health savings account (HSA)
Another tax-advantaged account, the HSA is available to individuals who are covered by an eligible high-deductible health plan. The HSA allows you to invest money on a tax-deferred basis and withdraw funds (tax-free) for qualified medical expenses.
As a bonus, you can withdraw funds after age 65 just like a regular IRA account.
Read more: How to pick a health savings account
Taxable brokerage account
Standard brokerage accounts allow you to invest with no limits (though without tax savings). These accounts can be open within any popular investing app, and allow more flexibility than retirement accounts.
One tax advantage is the ability to employ tax-loss harvesting, selling losing assets to lower your tax burden for the year.
Read more: Best online brokerage accounts for beginners
7. Keep some money in fixed-income assets
Diversification includes protecting your money by putting some aside in cash or in fixed-income assets. This allows you to invest your money with a much lower risk of loss, while taking advantage of income-generating investments at the same time.
The yields on these investments are typically lower, but it keeps some of your portfolio safe from massive market downturns.
Some examples of fixed-income assets include:
- Dividend stocks. While there is still more risk than bonds or cash, dividend-paying stocks can provide a steady yield and less volatility than growth stocks and other investments.
- Bonds. While not all bonds are created equal, government and corporate bonds can provide monthly or quarterly income payments with less downside risk than other assets.
- Certificates of deposit (CDs). CDs offer a fixed interest rate for locking up your cash for a certain amount of time. The longer the term, the higher the interest rate (typically).
- High-yield savings account (HYSA). HYSAs provide higher-than-average interest on cash savings, typically paying 10x to 20x more than a standard savings account. This can provide monthly interest without the risk of other assets, plus the investment is highly liquid. There may be withdrawal limits for these types of accounts.
Read more: Best high-yield savings accounts
Fixed-income investments allow you to preserve your capital while enjoying a modest return, but don’t expect these investments to grow your wealth as fast as other asset classes.
Why diversifying your portfolio is important
There is a level of uncertainty in every financial market. If you put all your money in stocks, you risk losing everything if the stock market crashes. The same applies to the real estate market, commodities markets, currencies, and any other investment. However, all markets hardly crash at the same time, in the same manner.
The same applies to investments in the same asset class. For instance, two stocks of different companies in different sectors fluctuate differently. By diversifying, the probability of losing a significant amount of money or your entire investment is very low.
Diversification is important to building a long-term, sustainable portfolio that doesn’t have the wild swings of investing in individual stocks or crypto, but still enjoys modest growth. It also can help you accomplish different investing goals, such as more passive income, funding a stable retirement, and simply the ability to sleep well at night.
Diversifying is more than just buying some stocks and bonds, but can include different account types, different asset classes, and even investing in small businesses. Just make sure to understand your investing goals, timelines, and risk tolerance before building an investment portfolio.