Diversified Portfolio

What Is It?

A diversified portfolio is one that contains a variety of different assets that act to reduce overall portfolio volatility (risk). The diversification in such a portfolio can refer to diversification across regions, sectors, and asset classes.

For instance, a portfolio composed of stocks and bonds based in the U.S., Europe, the Middle East, and Asia would be considered to be a diversified portfolio.

A portfolio containing an assortment of European stocks, for example, would not be considered as thoroughly diversified as a portfolio containing stocks from countries across the globe as described above. The more individual securities and different asset classes in a portfolio, the greater the diversification. While higher levels of diversification reduce portfolio volatility more significantly than lower levels, at some point a threshold is reached where further diversification has little effect on reducing idiosyncratic (single stock) risk.

Diversification among stocks or bonds in a single market reduces idiosyncratic risk associated with owning a single stock (or a small number of stocks). It does not eliminate market, or systematic, risk – meaning that if the market as a whole falls, diversification will not prevent your portfolio from falling in value along with the market.

The same principle applies to investing in individual markets as opposed to investing in a variety of different markets. Diversification across markets does reduce single market risk, but doesn’t eliminate the risk that a majority of markets all move in the same direction.

Different types of asset classes such as stocks and bonds may move in different directions, thus a portfolio containing both stocks and bonds is typically considered to be more diversified than one with just stocks or just bonds.

What Is It Used For?

Diversification reduces portfolio volatility by minimizing the impact of a dramatic move in the price of any one security or market. It is a powerful tool for reducing the overall risk of your portfolio while still allowing you to take advantage of the growth potential offered by investing in stocks. The following scenarios illustrate how a diversified portfolio minimizes single stock risk:

  • Your portfolio contains a single stock, which declines substantially in price after announcing poor earnings, devastating the value of your portfolio
  • Instead of owning a single stock (or just a few stocks), you own an ETF (exchange traded fund) that is based on the S&P 500 index, and one of the stocks that is part of the index announces poor earnings, driving its stock price down
  • The downturn in this individual stock is balanced out by the fact that the stock in question makes up only a small part of the index as a whole, so the ETF you own does not experience a major negative impact as a result
  • The use of ETFs allows you to create a diversified portfolio that will be less subject to volatility caused by the movement of a single stock than would be the case if you invested in just that single stock or a small number of stocks. Additionally, if your portfolio is diversified across different investment types and geographical locations, and a downturn takes place in one asset class or market, your portfolio is likely to be less affected because that asset class or market constitutes only a small portion of your overall holdings.
  • By eliminating or significantly reducing single stock, single asset, or single market risk, a diversified portfolio helps reduce the level of uncertainty involved with establishing and achieving your financial goals.

Other Considerations

While a diversified portfolio reduces risk, it also restricts possible returns. A well-diversified portfolio will typically achieve similar returns to the market (or markets) as a whole. Investors seeking returns far in excess of the market must take greater risk to do so, and therefore will typically prefer portfolios that are not so diversified that they mirror the market’s performance. While diversification can help dampen the impact of market volatility, it does not eliminate the risk of a broad-based decline in a variety of markets. If stock markets around the world fall simultaneously, then a diversified portfolio of global stocks will fall as well. In such cases, diversification that includes different asset classes can prove useful, as bond-based funds and ETFs may rise, or at least hold their value, while stock-based funds and ETFs are falling, lessening the impact of a decline in global stock markets.