Diversification means, simply, having a broad variety of investments so that your portfolio isn't overly dependent on any single investment. By diversifying, you can find the balance between potential risks and rewards that best suits your particular circumstances and goals.
How can I create a diversified portfolio?
The two most popular types of investments are
stocks and
bonds. If suitable, it's generally a good idea for your portfolio to have both of these kinds of investments. Stocks generally offer the potential for higher returns than bonds. But they also tend to be more volatile and carry more risks. Because they're generally more stable, bonds can help offset those risks and sometimes gain in value when stocks falter. But the returns they may offer are usually more modest.
What are some ways I can further diversify my portfolio?
Within both stocks and bonds, you can diversify by company size, particular industries, even geography. Stocks of smaller companies (called small caps) often offer strong growth potential, but with higher risks than other kinds of stock. Larger, more established companies (called large caps) may not grow as quickly but tend to offer less risk. Having both in your portfolio can be one way of diversifying. And because individual industries respond differently to market conditions, you may want to invest in a variety of sectors, such as industrials, technology or energy. Investing in certain mutual funds that contain many different stocks may also help you diversify.
"Because individual industries respond differently to market conditions, you may want to invest in a variety of sectors, such as industrials, technology or energy."
— Marci McGregor, Director, Chief Investment Office, Merrill and Bank of America Private Bank
To find the investment mix that meets your individual needs for diversification, you need to consider several factors, including your degree of comfort with risk and your time horizon — how long you have to reach your goals. If you have a number of years to recover from market downturns, you may want to think about choosing investments with potentially higher risks and rewards. With a shorter time horizon — if, say, you're getting close to retirement — you might want to stay with safer investments.
Over time, as some of your investments do better than others, your portfolio may become less diversified. That's why it's usually a good idea to revisit your portfolio regularly and see whether you need to make any changes to bring it back into balance.