When you diversify your investments across large and small companies, domestic and international, and stocks and bonds, you avoid the risk of putting all of your eggs in one basket.
Diversification is not designed to optimize returns. At any given time, investors who concentrate capital in a small number of investments may outperform a diversified investor. Over time, a diversified portfolio outperforms the majority of more concentrated ones. This fact emphasizes the difficulties in selecting only a few winning investments.
Owning investments that perform differently in similar markets is a crucial for diversification. Bond yields typically fall when stock prices rise. Professionals believe stocks and bonds are negatively correlated. Even when stock prices and bond yields move in the same direction (both gaining or losing), stocks typically have much higher volatility—that is, they gain or lose much more than bonds.
One of the most important decisions investors make when it comes to diversification is how much capital to invest in stocks versus bonds. Deciding to tilt a portfolio more toward stocks rather than bonds boosts growth at the expense of increased volatility. Bonds are less volatile than stocks, but growth is generally slower.
Time horizon is a major factor here.
Stocks are generally recommended for younger investors because they outperform bonds over the long term. As a result, a typical retirement portfolio will allocate 70 percent to 100 percent of assets to stocks.
However, as an investor approaches retirement, it is common for the portfolio to shift more toward bonds. While this change reduces the expected return, it also reduces portfolio volatility as a retiree begins to convert their investments into a retirement paycheck.
Stocks and bonds can be classified by industry or sector, and purchasing stocks or bonds from companies in different industries provides solid diversification. Some Exchange Traded Funds (ETFs) for example, track tracks the performance of an index or a “basket” of securities (such as shares, bonds, commodities, etc.) from different industries. ETFs are listed on a stock exchange and traded much like stocks, they provide investors with the opportunity to diversify their investments at relatively lower costs and gain exposure to different asset classes and strategies.
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