Investing

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The guide to diversification

Key takeaways

  • Diversification can help manage risk.
  • You may avoid costly mistakes by adopting a risk level you can live with.
  • Rebalancing is a key to maintaining risk levels over time.

It’s easy to find people with investing ideas—talking heads on TV, or a “tip” from your neighbor. But these ideas aren’t a replacement for a real investment strategy that can help you achieve your goals no matter what surprises the market serves up.

We believe that you should have a diversified mix of stocks, bonds, and other investments, and should diversify your portfolio within those different types of investment. Setting and maintaining your strategic asset allocation are among the most important ingredients in your long-term investment success.

Then give your portfolio a regular checkup. At the very least, you should check your asset allocation once a year or any time your financial circumstances change significantly—for instance, if you lose your job or get a big bonus. Your checkup is a good time to determine if you need to rebalance your asset mix or reconsider some of your specific investments.

Why diversify?

The goal of diversification is not necessarily to boost performance—it won’t ensure gains or guarantee against losses. Diversification does, however, have the potential to improve returns for whatever level of risk you choose to target.

To build a diversified portfolio, you should look for investments—stocks, bonds, cash, or others—whose returns haven’t historically moved in the same direction and to the same degree. This way, even if a portion of your portfolio is declining, the rest of your portfolio is more likely to be growing, or at least not declining as much.

Another important aspect of building a well-diversified portfolio is trying to stay diversified within each type of investment.

Within your individual stock holdings, beware of overconcentration in a single investment. For example, you may not want one stock to make up more than 5% of your stock portfolio. Fidelity also believes it’s smart to diversify across stocks by market capitalization (small, mid, and large caps), sectors, and geography. Again, not all caps, sectors, and regions have prospered at the same time, or to the same degree, so you may be able to reduce portfolio risk by spreading your assets across different parts of the stock market. You may want to consider a mix of styles too, such as growth and value.

When it comes to your bond investments, consider varying maturities, credit qualities, and durations, which measure sensitivity to interest-rate changes.

Diversification has proven its long-term value

During the 2008–2009 bear market, many different types of investments lost value at the same time, but diversification still helped contain overall portfolio losses.

Consider the performance of 3 hypothetical portfolios: a diversified portfolio of 70% stocks, 25% bonds, and 5% short-term investments; an all-stock portfolio; and an all-cash portfolio. As you can see in the table below,1 a diversified portfolio lost less than an all-stock portfolio in the downturn, and while it trailed in the subsequent recovery, it easily outpaced cash and captured much of the market’s gains. A diversified approach helped to manage risk, while maintaining exposure to market growth.