Portfolio diversification is an investment strategy that works to manage risk while capitalizing on gains. Instead of pursuing only aggressive growth (high risk) or decades of incremental gains (low risk), diversified portfolios mix investments to produce a happy medium (at least in theory).

🤔 Understanding portfolio diversification

There are several ways to diversify your portfolio.

By asset class

In investing, the main asset classes include:

• Cash and equivalent: Treasury Bills, CDs, money market securities, etc.
• Stocks (equities): shares purchased from a publicly traded company
• Bonds: fixed-income securities (IOUs)
• ETFs: a “basket” of securities from a specific index, sector, etc.
• Real estate: buildings, land, water and mineral deposits, agriculture, and livestock
• Commodities: goods that produce other goods or services

By stock or bond type

Depending on what types of securities you purchase, there are several ways to diversify investments. For instance, an investor who focuses on stocks may decide to split investments 50/50: half in dividend-paying stocks, half in aggressive growth stocks. Alternatively, a different investor may select to invest 50% of their stock portfolio in blue chip companies, with the other half reserved for startups.

Investors who put money into bonds have a vast array of options, as well. In addition to choosing bonds by issuer (company versus federal government, etc.), it’s possible to choose bonds by whether they pay interest or have other mitigating factors. For example, a bond investor can choose to put their money into:

• U.S. Treasury bonds
• TIPS (Treasury bonds that pay interest and adjust for inflation)
• State and municipal bonds
• Investment-grade corporate bonds
• High- or low-yield corporate bonds

By sector

Another way to diversify a portfolio is to spread investments across several sectors. For instance, some investors like to rely heavily on the aggressive growth of the technology industry to bolster their profits. However, this industry can be incredibly volatile, so moving some capital into other industries, such as manufacturing or healthcare, could be a wise decision.

One of the benefits of diversifying across sectors is that this can be done with almost any type of investment. Those who prefer stocks can select from any publicly traded company that offers stocks; those who like bonds can purchase bonds from any company that issues bonds, etc. Sector diversification is even possible in real estate, where investors can choose the type of real estate they prefer – housing, healthcare facilities, factories, etc.

By market capitalization

Market capitalization, or market cap, is how much a company is worth in terms of outstanding stocks. In other words, market cap is how much the company would have to pay in order to purchase all of its stock back from its shareholders.

Investors who diversify according to market cap have three basic “types” to choose from:

• Small cap companies, generally defined as a market cap between $300 million and $2 billion
• Midcap companies, generally defined as a market cap between $2 billion and $10 billion
• Large cap companies (also called big cap), generally defined as a market cap above $10 billion

While each market cap comes with its own potential risks, a well-diversified portfolio will take advantage of all the benefits from each to offset these risks.

What this means for you

Portfolio diversification of any kind is the equivalent of not putting all your eggs in one basket. It helps you to maximize returns and reduce risk by spreading your investments around. A well-diversified portfolio is likely to perform better in the long run.