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What’s Diversification and Why Is It Important?

By Sylvia Kwan

Diversification. It’s one of those investing buzzwords that people throw around but don’t actually explain.

Maybe you read that diversification’s good for your investment portfolio. Maybe you even know that it’s because diversification reduces risk. But why? And how?

What’s Diversification and Why Is It Important?

What is diversification?

Diversification is basically not putting all your financial eggs in one basket. It means building an investment portfolio that’s made up of many different types of investments that behave in different ways.

You can diversify across asset classes so that you own both stocks and bonds — and maybe even some alternatives. And within those asset classes, you can diversify even further. For example, you can own stocks in large companies, small companies, tech companies, oil companies, US companies, foreign companies ... you get the picture. Same for owning different types of bonds.

How does diversification help an investment portfolio?

If you own lots of different investments that all behave differently, then if one of them isn’t performing well, another may be performing better. And the risks that affect each individual investment will pose less risk to your investment portfolio as a whole.

Let’s look at a super-simplified example. Imagine you decide to invest your money in a shoe company. If you were to invest all of it in a company that only made rain boots, then the more it rained, the more money you’d (theoretically) make. But if it didn’t rain much that year, you’d be in trouble. On the other hand, if you were to invest in a company that only made sandals, you’d face the opposite situation. But if you were to split your money between the two, you’d be able to benefit from at least some of your investments no matter what the weather did.

So the key to diversifying your portfolio is to choose investments that aren’t highly correlated to one another. That means the things that affect one investment won’t affect the other investments in the same way. For example, stocks and bonds often (although not always) move in opposite directions — as stocks go up, bonds go down, and vice versa. That’s because when investors are nervous about the stock market, they often turn to bonds instead.

Of course, diversification has the opposite effect too: If one of your investments were to do really well, your portfolio wouldn’t grow as much as it would have if all your money had been in that single investment (think if you went with sandals and then it never, ever rained in our example above). But that would have been a really, really risky approach because nobody can predict what will happen to an investment in the future.

Diversification can’t get rid of all the risk of investing. Nothing can do that. There will always be certain risks — like global recession, regulatory risks, or outlier scenarios like the 2008 financial crisis — that could definitely affect your investments.

How Ellevest uses diversification

Diversification is our BFF. It’s at the center of our online investing strategy. And here’s the best part: When you invest with Ellevest, we’ll take care of diversifying your investment portfolio for you, depending on what we think will be most likely to help you hit your goals. Then we’ll automatically make adjustments whenever it strays too far from that recommendation (which happens, since the value of the individual investments in your portfolio will probably go up and down).

Plus, the investments we use to build our portfolios are not actually individual stocks or bonds — they’re exchange-traded funds (ETFs). (So if your Ellevest portfolio is composed of 85% stock and 15% bonds, for example, that means 85% of your investment portfolio is held in stock ETFs and 15% is held in bond ETFs.) When you own an ETF, you actually own a share of a fund that contains lots of individual investments. That means ETFs come with built-in diversification. That’s diversification on top of your diversification, for those of you keeping track at home.

See ya later, investing buzzword — consider yourself officially demystified.

So … ready to get started?


Disclosures

© 2019 Ellevest, Inc. All Rights Reserved.

The information provided should not be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice.

The information provided does not take into account the specific objectives, financial situation or particular needs of any specific person.

Diversification does not ensure a profit or protect against a loss in a declining market. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income

Investing entails risk including the possible loss of principal and there is no assurance that the investment will provide positive performance over any period of time.

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Sylvia Kwan

Sylvia is the Chief Investment Officer of Ellevest. She researches and oversees Ellevest portfolios and develops the algorithms behind Ellevest’s investment recommendations.