"Don't Put All Your Eggs in One Basket"
This old adage is the essence of diversification. The goal of diversification is not necessarily to boost performance—it won't guarantee gains or insure against losses—but to reduce the volatility of your portfolio over time. By investing in a variety of assets that are not perfectly correlated, you can smooth out your returns.
How Diversification Works
Different asset classes often perform differently under various market conditions. For example, when the economy is strong, stocks may perform well, but when the economy weakens, government bonds may perform better. By holding both stocks and bonds, the poor performance of one asset class can be offset by the strong performance of another, leading to a more stable portfolio value.
Levels of Diversification
Diversification can be applied at several levels:
- Across Asset Classes: This is the most important level, involving a mix of stocks, bonds, and cash.
- Within Asset Classes: This involves diversifying within a single asset class. For example, within your stock allocation, you should own stocks from different industries (e.g., technology, healthcare, financials) and different geographic regions (e.g., U.S., international, emerging markets).
The Role of Mutual Funds and ETFs
For most individual investors, the easiest and most effective way to achieve diversification is by investing in low-cost mutual funds and ETFs. A single broad-market index fund can give you exposure to hundreds or even thousands of different stocks, providing instant diversification at a very low cost.
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