Understanding how to diversify your portfolio is one of the most effective ways to manage investment risk.
Diversification means investing in different assets that don’t always move up or down at the same time. This can lower how much your overall portfolio goes up and down, without drastically reducing the returns you might expect to earn over long periods of time.
This charts outlines portfolios of stocks and bonds composed of the S&P 500 and Bloomberg Aggregate Bond index. Blue bars represent the annualized returns of the portfolio, while gold bars represent the volatility. Volatility is represented by the standard deviation in value of the portfolio. The black dotted line shows the ratio of annual returns to volatility of each portfolio. Date Range: 15 years ago to present. Source: Clearnomics, LSEG
When you combine these different assets, the total risk of your portfolio can be less than just adding up each asset’s risk by itself.
That's the magic of portfolio diversification!
But...
Findings from Reinholtz, Fernbach, and Langhe show that most people do not fully understand how diversification works. Many believe there is no benefit to spreading money across different investments.
Some people, especially those who know less about finance, think that holding different types of assets actually makes a portfolio swing more wildly. They imagine each asset’s ups and downs piling on top of each other.
The truth is that diversification is a powerful component of investment management. But, investors often struggle to figure out where to begin.
Imagine you’re approaching retirement with a significant nest egg—perhaps over $1 million in investments—and you worry about how to protect what you've worked so hard to save.
You may find yourself asking, “Is my portfolio balanced enough? Am I too heavy in stocks, bonds, or a particular sector?” These concerns can weigh on your mind, especially during market downturns.
In this article, we’ll delve into the concept of diversification, explore common strategies, and look at best practices for reducing risk in your portfolio.
Keep reading to discover actionable insights you can apply today to safeguard your retirement goals and preserve your peace of mind.
Key Takeaways
Diversification spreads your money across multiple asset classes to help reduce overall portfolio risk.
Rebalancing ensures your portfolio stays aligned with your goals and risk tolerance.
Different asset classes—stocks, bonds, real estate, and alternatives—can provide unique returns and different levels of risk.
International investments may offer growth opportunities and enhanced diversification benefits.
A mix of passive and active investments can balance cost-efficiency with targeted strategies.
Staying informed and periodically reviewing your investments can keep your diversification strategy on track.
Professional guidance, such as working with Covenant Wealth Advisors, can help tailor a plan to your unique circumstances.
Table of Contents
See How Our Firm Can Help You Retire With Confidence
Retirement Planning - Find when you can retire and if you'll be able to maintain your lifestyle.
Investment Management - Personalized investing to grow and protect your wealth in retirement.
Tax Planning - Identify tax strategies including Roth conversions, RMD management, charitable giving and more...
What Is Diversification?
Diversification involves spreading your money across different types of investments, such as stocks, bonds, real estate, and sometimes alternatives like private equity or hedge funds. By not relying on a single asset class, you reduce the chance that one poor-performing investment will significantly harm your overall portfolio.
In simpler terms, think of diversification like a buffet.
If you only eat one type of food, you might miss out on essential nutrients. But if you fill your plate with fruits, vegetables, proteins, and grains, you’re more likely to get a balanced meal.
In the same way, a well-diversified portfolio aims to balance out the ups and downs of the market, offering a smoother investment experience over the long term.
Diversification doesn’t guarantee profits or protect against all losses. However, it’s widely recognized—by experts and organizations like Investor.gov—as a core principle for prudent investment tips.
Common Asset Classes to Consider
Stocks (Equities)
Stocks represent ownership in a company. They can offer higher growth potential but also come with more volatility. Large-cap, mid-cap, and small-cap stocks all behave differently, so consider including a range of company sizes. You can also look beyond U.S. borders for added diversification in international or emerging-market equities.
This chart shows the annual returns and largest intra-year decline for the S&P 500 price index. The largest intra-year decline is measured as the steepest peak-to-trough decline for the index during the calendar year. Date Range: January 2, 1980 to present. Source: Clearnomics, Standard & Poor's
Bonds (Fixed Income)
Bonds are essentially loans to governments or corporations. While they generally provide lower returns than stocks, they also offer more stability. According to Morningstar, the bond market can act as a buffer when stocks falter. Different types of bonds—government, municipal, corporate—have varying degrees of risk and reward.
This chart shows the annual returns and largest intra-year decline for the Bloomberg U.S. Aggregate Index using total returns. The largest intra-year decline is measured as the largest peak-to-trough decline during the calendar year. Date Range: 1988 to present. Source: Clearnomics, Bloomberg
Real Estate
Real estate can be accessed through direct property ownership, Real Estate Investment Trusts (REITs), or mutual funds that invest in real estate companies. Real estate often moves differently than stocks and bonds, making it a valuable diversifier. Keep in mind, however, that real estate investments can be less liquid and more location-dependent.
Alternatives
Alternative investments, such as commodities, private equity, hedge funds, or even cryptocurrencies, can further broaden a portfolio. These assets may not always move in tandem with traditional markets, thus providing an additional layer of diversification. However, alternatives can come with higher fees, lower liquidity, and more complexity, so it’s essential to approach them with caution.
Andrew Casteel, CFP® at Covenant Wealth Advisors in Reston, VA says “Alternative investments can potentially provide uncorrelated diversification for some portfolios, but we often recommend starting small and focusing on assets that align with your overall goals and risk profile.”
Strategies for Effective Portfolio Diversification
Asset Allocation
Asset allocation is the process of deciding what percentage of your portfolio goes into each asset class—stocks, bonds, real estate, and so on. This initial decision can often matter more than individual stock or fund selection. For example, you might decide to allocate 60% to equities, 30% to fixed income, and 10% to real estate. The ideal allocation depends on your financial goals, risk tolerance, and time horizon.
The chart above tracks the performance of four portfolio allocations: 100% stocks, a 60%/40% stock bond split, 40%/60% stock bond split, and a 100% bonds. This chart are reindexed to the beginning of 2008 to show performance relative to the Great Recession. The dotted vertical lines show the annotated performance events. The 100% stock portfolio is represented by the S&P 500, while the other three use iShares U.S. Bond indices before expenses and fees. Date Range: January 2, 2008 to present. Source: Clearnomics, Standard & Poor's, Refinitv.
Geographic Diversification
Investing globally can potentially lower risk. Markets in different regions do not always move together, so international investments may act as a cushion during U.S. market downturns. Consider including funds or ETFs that track both developed and emerging markets for broader global coverage.
Sector Diversification
Even if you invest primarily in U.S. equities, spreading your money across multiple sectors—technology, healthcare, consumer staples, utilities, and more—can help guard against sector-specific downturns.
💡 Pro Tip: Revisit your sector allocations each year. Market movements can skew your original allocations, and periodic adjustments can help you maintain the right balance.
If your entire portfolio is concentrated in tech stocks, for instance, any slump in that sector could disproportionately affect your returns.
This chart shows the annual total returns for the S&P 500 and each S&P 500 Global Industry Classification Standard (GICS) sector. GICS sectors include communication services (Comm.), consumer discretionary (Cons. Disc.), consumer staples (Cons. Stap.), energy, financials, health care, industrials, information technology (technology), materials, real estate, and utilities. Date Range: January 2, 2008 to present Source: Clearnomics, Standard & Poor's, LSEG
Blend Active and Passive Funds
Active funds allow portfolio managers to make specific picks based on research and expertise, while passive funds track indexes like the S&P 500. A combination of both strategies can offer the best of both worlds: cost-efficiency from index funds and potential outperformance from actively managed funds. Keep fees in mind; higher costs should justify the potential benefits of active management.
Factor and Style Diversification
Consider including different investment styles—like value and growth—and factor-based strategies—like small-cap vs. large-cap or low-volatility vs. high-volatility. By doing so, you avoid relying on one type of strategy that might only perform well under specific market conditions.
This chart shows the MSCI USA Factor Index Returns. Each column represents a year. Each square shows the index returns for the year and are ordered from lowest returns at the bottom to highest at the top. Date Range: 17 years ago to present. Source: Clearnomics, MSCI, LSEG
Monitoring and Rebalancing Your Investments
Set a Schedule
Regularly reviewing your portfolio—quarterly or semi-annually—helps you see if any asset class has become overweight or underweight. For instance, if your equities have skyrocketed, they might now make up a larger portion of your portfolio than intended, increasing overall risk.
Rebalancing Tactics
Rebalancing involves selling assets that have grown beyond your target allocation and buying those that have fallen behind. This process encourages you to “buy lower and sell higher,” a fundamental concept in investing.
This chart shows the current composition of a stock and bond portfolio that was created in 2009, but never rebalanced. Stocks and bonds are represented by the S&P 500 and Bloomberg Aggregate Bond Index, respectively. The white dotted lines show the starting allocation. Source: Clearnomics, LSEG
Keep in mind, however, that frequent rebalancing can trigger transaction fees and tax implications. While it's important to rebalance, you should also understand how often to rebalance based on your particular situation.
Tax Efficiency
When rebalancing in taxable accounts, consider strategies like tax-loss harvesting, which involves selling investments at a loss to offset gains elsewhere. Tax-loss harvesting requires careful attention to rules like the wash-sale rule. Always consult with a tax professional before making major moves, as individual circumstances vary.
“Successful investors often focus more on consistent rebalancing and discipline rather than chasing hot stocks or timing the market.” says Mark Fonville, CFP at Covenant Wealth Advisors in Richmond, VA.
FAQs
Q1: Why is portfolio diversification so important?
Diversification helps limit the impact of any single investment’s poor performance on your overall portfolio. By investing in multiple asset classes and sectors, you reduce the chance that a downturn in one area will dramatically affect your total returns. This is particularly important for individuals over 50, who may not have as much time to recover from market losses before retirement.
Q2: Can I be diversified by owning just a few mutual funds or ETFs?
It’s possible, but you need to ensure those funds or ETFs offer broad coverage of different asset classes and sectors. Simply holding two or three funds might still leave you too concentrated if they track similar benchmarks or invest in similar stocks. Look for funds with distinct focuses—such as a total stock market fund, an international equity fund, and a bond fund—to achieve a more balanced approach.
Q3: How often should I review and rebalance my portfolio?
A semi-annual or annual review works well for many investors. However, you may want to rebalance more frequently if there have been significant market swings or if your portfolio allocations drift well beyond your target ranges. Always keep transaction fees and taxes in mind, as frequent changes can impact your net returns. Here's a more detailed article on how often to rebalance.
Q4: What role does my risk tolerance play in how to diversify my portfolio?
Risk tolerance is a key factor in determining your asset allocation. If you’re uncomfortable with the potential for large losses, you may opt for a higher percentage of bonds or other more stable assets. On the other hand, if you have a higher risk tolerance and a longer time horizon, you might include more growth-oriented equities in your portfolio.
Q5: Should retirees still diversify?
Yes. Retirees, in particular, benefit from diversification to help preserve capital while also allowing for some growth. A balanced approach can provide steady income from bonds and dividends, while equity exposure can help outpace inflation over the long term. Diversification becomes even more critical as you seek to protect the nest egg you rely on in retirement.
Conclusion
A sound diversification strategy weaves together various asset classes, geographic regions, and investment styles to help reduce your exposure to market downturns. By carefully monitoring and rebalancing your portfolio, you aim to stay aligned with your long-term goals, especially if you’re close to retirement or already retired. Remember, diversification does not eliminate risk entirely, but it can mitigate it by spreading that risk across a broader landscape.
Ultimately, how to diversify your portfolio depends on your personal financial situation and comfort with market fluctuations. If you’re uncertain about your current holdings or feel overwhelmed by the array of investment options, consider seeking professional advice. Working with an advisor, like the team at Covenant Wealth Advisors, can bring clarity to your plan and help tailor a strategy that fits your unique needs.
Would you like our team to help you properly diversify your investment portfolio?
About the author:
Senior Financial Advisor
Scott is a Financial Advisor for Covenant Wealth Advisors, a CERTIFIED FINANCIAL PLANNER™ practitioner and a Certified Public Accountant (CPA). He has over 17 years of experience in the financial services industry in the areas of financial planning, tax planning, and investment management.
Disclosures: Covenant Wealth Advisors is a registered investment advisor with offices in Richmond, Reston, and Williamsburg, VA. Registration of an investment advisor does not imply a certain level of skill or training. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. The views and opinions expressed in this content are as of the date of the posting, are subject to change based on market and other conditions. This content contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Please note that nothing in this content should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax, or legal advice. If you would like accounting, tax, or legal advice, you should consult with your own accountants or attorneys regarding your individual circumstances and needs. This article was written and edited by a CERTIFIED FINANCIAL PLANNER™ professional with the assistance of AI. No advice may be rendered by Covenant Wealth Advisors unless a client service agreement is in place. Hypothetical examples are fictitious and are only used to illustrate a specific point of view. Diversification does not guarantee against risk of loss. While this guide attempts to be as comprehensive as possible but no article can cover all aspects of retirement planning. Be sure to consult an advisor for comprehensive advice.