What’s the purpose of a diversified portfolio?

The short answer: The better you spread your investments across different assets, the less likely they are to all experience a loss. Or in other words, your aggregate losses will likely be less severe.

A diversified portfolio is kind of like a nutritious diet...

However, diversification isn't a cure-all, or a guaranteed safeguard. Similarly to how a balanced diet won't protect you from ever getting sick (we all get ill from time-to-time), having a diversified portfolio doesn't mean your investments will never drop, or even drop dramatically -- Diversification is simply a strategy that can help you prevent losses from being as severe as they could be otherwise, and has the potential to help bring less volatility to your returns.

The more varied and diversified your investments are, the better able they are to help you mitigate losses.

There’s no shortage of choice when it comes to where you can invest your money. In addition to stocks and bonds, there are money market funds, real estate, commodities, private equities, and so on. What’s more, within each investment class, you can put your money in different companies, industry sectors, geographies, and currencies.

With a diversified portfolio, the idea is that the more varied your collection of asset classes and funds, the better it can mitigate losses. Markets tend to work in cycles, and different markets may go up or down at different times. In theory, a diversified portfolio can help your investments so if a few markets take a hit one year, other parts of your portfolio might continue to grow.

So what kind of mix is right for you?

The answer depends on who you are and what you are trying to achieve with your investments. You might decide to invest more money in one class or sector over another based on your financial needs, personality, and timeline.

Before you go about diversifying your portfolio, it’s a good idea to ask yourself the following questions:

• What are the main reasons you want to invest? Maybe you’re trying to save money for an emergency. Maybe you’re trying to pay off your credit card debt or a student loan. Maybe you want to start contributing to a retirement fund. For many of us, the answer probably includes all of the above. Whatever your goals are, knowing and prioritizing them ahead of time can help you identify what a “diversified portfolio” looks like for you.
• How well do you tolerate risk? One common dynamic in investing is that you need to take bigger risks in order to see bigger rewards. This might mean putting a higher percentage of your investment into stocks vs. bonds. At the end of the day, every investment carries some level of risk, and for most of us, the idea of losing money can be stressful. Ideally, a diversified portfolio would help you reduce risks while obtaining the best returns possible with that portfolio. But to know how much risk you can take in your portfolio, it helps to know how well you can handle stress, both financially and emotionally.
• What’s your investment timeline? One piece of advice you might hear from investors is that the sooner you start saving, the better. In theory, because of things like compounding, the longer you leave your investment untouched, the better potential it has to grow. But your timeline may vary depending on your goal. For example, if your goal is more immediate, like having an emergency fund, you may only want to give yourself one year to save. If you’re saving for retirement, your time frame might be as long as 30 years or more. Knowing your timeline can help you determine how quickly you need your investment to grow, and how much risk you’re willing to take along the way.

Here a three examples of major asset classes:

• Stocks can be one of the most volatile asset categories. In other words, one year the returns from a stock could be very high, followed by a steep loss the next year. Stock investments can have a lot of potential for large returns, but this is typically true for investors who are willing to ride out several boom and bust cycles, which can take a long period of time.
• Bonds are generally considered a safer source of returns than stocks, but their returns are also on average lower. Think of them as a lower risk, lower reward category.
• Cash and cash equivalents can include your typical savings account, as well as treasury bills and money market accounts. They’re often considered the safest places to invest, but they’re also known to yield some of the lowest returns over time of the major asset categories.

Keep in mind that each of these categories can consist of an array of companies, industries, and geographic regions. And there’s a whole range of categories beyond these three. Real estate, commodities (like gold, oil, water)... the list goes on. The important thing to know is that each investment category and subcategory may have a different return on investment (ROI), depending on the year.

In the best case scenario, you can minimize your risk and maximize your rewards.

One year you might see the oil markets in Asia suffer a downturn, and in the same year, the real estate market in Europe might see a boom. If you’ve spread your investment across a variety of asset types, markets, and regions, your investments might have a better chance at growing overall or in major down markets preventing large losses. The process of divvying up your investments in this way is called asset allocation. The goal of a diversified portfolio is to better manage risk.

You don’t have to do it alone, but do your homework before you get help.

If coming up with a diversified portfolio on your own sounds a little too daunting, know that there are ways to get help. For example, there’s a whole variety of mutual funds and exchange traded funds. Think of them as curated investment playlists.

Keep in mind that pre-made packages are managed by professionals and require paying an annual management fee. You can also hire a professional, like an investment advisor, to help create and manage a portfolio that works best for your needs. Fees can add up, though, so it’s best to explore different options and understand the pros and cons of each. The good news is that you don’t have to do it on your own.

Diversifying your portfolio has many advantages, but it can also be a big responsibility. Especially for beginner investors, it can seem daunting to research different asset classes and decide where to allocate your money. Understanding diversifying and other investment strategies takes time. Even pre-made packages like mutual funds require doing a bit of research, and typically, any help you can get doesn’t come for free. And no strategy or professional can predict the future of your investment or guarantee its growth — There’s always going to be some risk involved. But if you’re willing to do a bit of homework and spare the time, diversifying can create the potential for a safer, smarter path to reach your investment destination.

It’s also important to note that while having a diversified portfolio can mitigate losses in a downturn and help you have more predictable portfolio movement, it does also mean that you might be limiting your returns during favorable markets, and in those periods, dampen your returns. In an upswing, for example, owning high-flying stocks could yield better returns than a standard mutual fund. But remember, less diversified portfolios generally mean more risk.

Additional disclosure: Diversification does not ensure a profit or eliminate the risk of investment losses.