Aug 24, 2018
Diversification: Spread the Risk for a Safer Nest EggBy Stash Team
It’s one of the elementary principles behind smart investing.
Update June 2022: If you’ve been watching the market, you might be feeling a little anxious. Inflation data, the Russia-Ukraine war, and anticipated monetary policy changes are contributing to increased market volatility. It's normal to feel nervous when the market goes down, but panic selling can hurt your portfolio rather than help it. We think it’s best to focus on the long-term, invest in a diversified portfolio and automate investing with Auto-Stash. Staying invested through all parts of a market cycle is key to long term investing success.
You’ve heard the phrase, “don’t put all your eggs in one basket.” If you drop the basket, you can wave goodbye to your eggs—and you’re likely to be left with a big mess!
The same can be true for investing; putting all your money into one investment might be risky. Spreading your risk is called diversification, and with this easy explainer, you’ll be diversifying your nest egg in no time.
Diversification: the tl:dr
What’s the point of diversification?
When you invest, you have a lot of choices. Sometimes it can feel like too many. You can put your money into stocks, bonds, funds, other securities—even real estate.
Diversification simply means you put your money into a diverse array of investments—not just one stock, or even a narrow selection of stocks, bonds, or funds. When you’re diversified, one of your baskets can fall—or one stock can tank—but the tumble won’t break all of your eggs, and your overall investments may remain stronger.
Note: All investing involves risk. And you can lose money in the market.
How does diversification work?
When markets go up, the value of your investments will likely go up as well. That means the money you’ve invested will grow. But when markets drop, the value of your investments will probably go down—and you could lose money. (If you’re curious about managing investments when the market is falling overall, this article can help you understand some of the ins and outs of market volatility.)
Here’s where diversification comes in: Stocks, bonds, and funds don’t rise or fall at the same rate. Therefore, investing in multiple stocks, bonds, and other assets, can spread your risk—which is sometimes called your “portfolio volatility.” (Note: Your portfolio is all your investments, and volatility is a measure of risk.)
Diversification in action
Let’s imagine a scenario with three stocks, and the market falls:
- Stock A drops by 60%
- Stock B drops by 30%
- Stock C drops by 20%
If you had invested only in Stock A, you’d lose 60% of your investment—ouch. But if you spread your money evenly across all three stocks you’d only lose 36.66%, which is the average of the percentage by which all three stocks dropped (to calculate the average, add 60+30+20. That equals 110; divide by 3 to get the average: 36.66%).
The same holds true when the market goes up:
- Stock A increases by 20%
- Stock B increases by 30%
- Stock C increases by 10%
If you spread your money evenly across all three stocks, your investment will increase by the average percentage that all three stocks went up. Here’s the math: 20+30+10=60. Divide 60 by 3, and you get an average of 20%.
If you hadn’t diversified, it would have been a bigger gamble: you would have a higher rate of return if you just bought Stock B—but if you picked Stock C, you would have missed out. Spreading your investment among stocks can smooth out the big dips and spikes in the market.
Three ways to diversify
Diversification is more than investing in more than one stock—it’s a way of approaching investment that keeps your eggs carefully placed in many baskets. Here are three important ways to consider diversification in your portfolio:
- Diversify by asset type. A diverse portfolio is one where you’ve invested in a broad mix of investment types, or “asset classes.” For example, your portfolio might include bonds, funds (like index funds and exchange-traded funds), cash, real estate, and commodities.
- Diversify by sector. You can also diversify within each asset class. For example, when you invest in stocks, you may not want a portfolio that contains all tech stocks or all energy stocks. With a diverse portfolio, a significant drop in one sector may not tank your entire stock portfolio.
- Diversify by geography. While it may be tempting to put all your money in U.S. securities, the world is a big place. You could also invest in Europe, Asia, and South America—just to name a few other regions. Keeping your investments geographically diverse (including both developed and emerging economies) can help spread your risk; even if economies in one region contract, others may grow.
Make diversification easy with funds
Funds can help make diversification simple—they’re like baskets that contain an assortment of stocks or bonds. Exchange-traded funds (ETFs) and mutual funds invest in dozens, hundreds, or even thousands of different stocks and bonds—basically, they do the diversification for you. When you purchase shares of the fund, you’re investing in the overall mix of stocks and bonds. Take a look at Stash’s EFTs to get a sense of the options.
Keep in mind, however, that the level of diversity within funds can vary—they may be narrowly focused or broadly focused. Narrowly focused funds might cover a single sector like technology or energy, making you more vulnerable to sector-specific market drops. In contrast, more broadly focused funds might contain an entire class of stocks, like those in the S&P 500—an index of the largest publicly traded stocks in the US, representing a variety of industries and sectors.
Some funds invest in bonds, which can be a critical part of a diverse portfolio. (Find out why in this bonds explainer.) Bonds are often seen as safer investments, and they can act as a counter-balance to stocks, frequently increasing in value when bonds decrease—and vice-versa. Another reason to look at diversification by asset type when you’re making your investment decisions.
Ready to start diversifying?
Diversification can sound complicated—there are a lot of choices. But remember, diversity and variety are the spice of life. And by diversifying, you can invest more confidently, which can help you stay committed as the market rises and falls.
Stash can help you diversify affordably. You can choose from hundreds of stocks and dozens of EFTs (composed of stocks and bonds) for one low monthly fee.