Putting all your eggs in one basket is a bold move. If that basket does well, you do well. But, if that basket flunks, you lose all those eggs. Rather than investing in just one or a few focused but similar stocks, portfolio diversification is an investment strategy that mixes up your money.
You can diversify your portfolio in different ways:
By Asset Class: Diversify across asset classes, such as in stocks, cash (treasury bills, CDs, money market
securities, etc.), bonds, ETfs, real estate and commodities, too.
By Type of Stock or Bond: Purchase various types of stocks and bonds, like dividend-paying stocks, aggressive growth stocks, blue-chip companies, startups, U.S. Treasury bonds, TIPS, state and municipal bonds, investment-grade corporate bonds, high- or low-yield corporate bonds and more.
By Sector: Move some of your capital into various industries like tech, healthcare, manufacturing and more. In case one experiences extreme volatility, your whole portfolio won’t plummet.
By Market Capitalization: Market capitalization refers to how much companies would have to pay should they purchase all stock back from shareholders. Diversify your portfolio by small-, mid- and large-cap companies.
By Correlation: Some stocks have histories of performing in unison together. Invest in assets that aren’t correlated so, if one moves south in the market, the others won’t necessarily follow suit.
By Risk-Reward Ratio: Select securities with varying risk-reward ratios—the dollar amount that you earn against the risk of your investment. Your overall portfolio, if well-diversified, can override the risks of individual securities.
While there’s no one right way to diversify a portfolio, most advisors will suggest the 5/25 rule: No more than 5 asset classes at once, and no more than 25 percent of the whole portfolio in any one asset class. However you choose to do it, a well-diversified portfolio tends to perform better over time—particularly over a period of 25 years or more. By spreading out your investments, inevitable market volatility won’t hit you as hard.
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