Why is diversification a good idea

Replete with a pool, beach and tennis courts, the resort booms when the sun is shining. Sometimes it rains, and when it does people want to buy umbrellas.

While the rainy season means big business for the umbrella maker, it means hard times for the resort. Nobody wants to drink Mai Tais in a thunderstorm. The opposite is true with umbrellas, although periods of rain and sunshine can be very hard to predict on our island. Same deal with a long rainy season. What should you do? Invest in umbrellas or resorts? Both, obviously. Diversification is an unalloyed good for investors, but it can be taken too far in certain cases. Here are a few of the risks of overdiversification:.

One of the most common issues that Elijah Kovar, a lead advisor at Minneapolis-based Great Waters Financial, sees when he meets with clients is owning too much of the same thing in different packages. When the stock market drops, so will your investments.

While owning two mutual funds that do the same thing might be a problem for solo investors, robo-advisors help you steer clear of that headache. Robos instead invest your funds in ETFs across a dozen or more asset classes to achieve a diversified portfolio that matches your risk appetite. The problem is that some will put you into funds that charge higher fees when you can get the same diversification with cheaper ETFs. For instance, you can invest in all of the publicly traded stocks in the U.

But many of the robo-advisors will slice and dice your asset allocation so you are invested in, say, iShares Dow Jones Select Dividend, which charges 0. This may effectively double your exposure to large, stable companies at a premium as both funds have heavy representation in that same industry.

In addition, the difference in dividends between these two types of funds may not be worth the extra fees and difference in performance. Of course, robo-advisors have their reasons for choosing one ETF over another, and sometimes their algorithms find that a fund with a higher expense ratio is worth the fee. But you also need to keep in mind that most robo-advisors charge their own annual management fees in addition to ETF fees.

Betterment and Wealthfront , for example, charge 0. While a robo will do all the work for you, a portfolio festooned with different funds may make you less likely to move to another investment firm or to learn how to do it on your own, even if such a move makes sense. While robos can slice and dice a diversified portfolio too finely in some cases, they at least get the job of diversification done. Left to your own devices, you might not do as well. In fact, you can do so with just three funds.

Three funds is all you need to gain exposure to large, medium and small U. Three funds will get you exposure to the foreign companies, from established players in Western Europe to fast-rising firms in emerging markets. Three funds will let you buy domestic debt from the federal government to higher-yielding riskier corporations to everything in between.

And the beauty is that these three funds can be cheap to own. To figure out what your portfolio allocation should be, check out our guide to retirement portfolio construction. Create a personalised ads profile. Select personalised ads. Apply market research to generate audience insights.

Measure content performance. Develop and improve products. List of Partners vendors. Diversification is a technique that reduces risk by allocating investments across various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event.

Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk.

Here, we look at why this is true and how to accomplish diversification in your portfolio. Let's say you have a portfolio that only has airline stocks. Share prices will drop following any bad news, such as an indefinite pilot strike that will ultimately cancel flights. This means your portfolio will experience a noticeable drop in value. You can counterbalance these stocks with a few railway stocks, so only part of your portfolio will be affected.

In fact, there is a very good chance that these stock prices will rise, as passengers look for alternative modes of transportation. You could diversify even further because of the risks associated with these companies. That's because anything that affects travel will hurt both industries. Statisticians may say that rail and air stocks have a strong correlation.

This means you should diversify across the board—different industries as well as different types of companies. The more uncorrelated your stocks are, the better. Be sure to diversify among different asset classes, too. Different assets such as bonds and stocks don't react the same way to adverse events. A combination of asset classes like stocks and bonds will reduce your portfolio's sensitivity to market swings because they move in opposite directions.

So if you diversify, unpleasant movements in one will be offset by positive results in another. And don't forget location, location, location. Look for opportunities beyond your own geographical borders. After all, volatility in the United States may not affect stocks and bonds in Europe, so investing in that part of the world may minimize and offset the risks of investing at home.

Obviously, owning five stocks is better than owning one, but there comes a point when adding more stocks to your portfolio ceases to make a difference.

There is a debate over how many stocks are needed to reduce risk while maintaining a high return. The most conventional view argues that an investor can achieve optimal diversification with only 15 to 20 stocks spread across various industries. Investors confront two main types of risk when they invest. The first is known as systematic or market risk.

This type of risk is associated with every company. Common causes include inflation rates, exchange rates , political instability, war, and interest rates. This category of risk is not specific to any company or industry, and it cannot be eliminated or reduced through diversification. It is a form of risk that all investors must accept. Systematic risk affects the market in its entirety, not just one particular investment vehicle or industry. The second type of risk is diversifiable or unsystematic.

This risk is specific to a company, industry, market, economy , or country. The most common sources of unsystematic risk are business risk and financial risk. Our editorial team receives no direct compensation from advertisers, and our content is thoroughly fact-checked to ensure accuracy. You have money questions. Bankrate has answers. Our experts have been helping you master your money for over four decades. Bankrate follows a strict editorial policy , so you can trust that our content is honest and accurate.

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Diversification means owning a variety of assets that perform differently over time, but not too much of any one investment or type. In terms of stock, a diversified portfolio would contain or more different stocks across many industries. But a diversified portfolio could also contain other assets — bonds, funds, real estate, CDs and even savings accounts.

Each type of asset performs differently as an economy grows and shrinks, and each offers varying potential for gain and loss:.

As some of these assets are rising rapidly, others will remain steady or fall. Over time, the frontrunners may turn into laggards, or vice versa. Diversification has several benefits for you as an investor, but one of the largest is that it can actually improve your potential returns and stabilize your results. By owning multiple assets that perform differently, you reduce the overall risk of your portfolio, so that no single investment can hurt you.

Because assets perform differently in different economic times, diversification smoothens your returns. While stocks are zigging, bonds may be zagging, and CDs just keep steadily growing. In effect, by owning various amounts of each asset, you end up with a weighted average of the returns of those assets.

Diversification reduces asset-specific risk — that is, the risk of owning too much of one stock such as Amazon or stocks in general relative to other investments. So diversification works well for asset-specific risk, but is powerless against market-specific risk.