What Is Diversification and Why Does It Matter?

You’ve likely heard the financial advice to “diversify your portfolio” many times before, but do you really know what it means and why it is so important?

Fortunately, the idea behind diversification is already something you are familiar with, and you likely apply it in many parts of your life without even thinking about it. For the beach, you’re likely bringing a swimsuit, T-shirt, and sandals. By contrast, for a wedding, you’re putting on a pressed suit or a new dress.

In other words, you are making decisions about what to wear and when to wear it based on what you are doing and where you are in your life—literally.

The same concept—making decisions about how to handle your money based on your goals and where you are in your life—applies to your financial portfolio. By the end of this article, you will be able to answer, “What is diversification and why does it matter?”

What is diversification?

Because our economies and investment markets are constantly changing and evolving, a continuously growing investment is almost an impossibility. Therefore, we must find the right balance between the risk of losing some of our hard-earned money when an investment value drops and the potential to lose out on investment gains by leaving an investment too soon.

This is where diversification, also known as asset allocation, comes in: It is the technique of spreading out your investments across a range of assets to reduce your overall risk between the ups and downs of the market. Essentially, you are using different financial products and investment techniques to spread out your financial assets across different asset classes (e.g., stocks, bonds, currencies, and cash investments), stock markets, domestic and international markets, and/or groups of investments to help you maximize your gains and minimize your potential losses.

Why does diversification matter?

You don’t have to be a full-time investor or a stock market enthusiast in your free time to notice the normal (and sometimes abnormal) ups and downs of the financial markets and how these moves affect the value of your investments.

However, at the same time, if you look behind these top-line numbers, there are still winners and losers during each cycle. For example, oil and gas stocks may take a hit one cycle while technology stocks continue a steady rise.

Diversification matters because it goes one or two layers deeper into the overall market behavior and takes advantage of the fact that not all investments will be winners (or losers) every day. In other words, by not putting all of our investment eggs in one basket, you spread out your risk and gains in a way that aligns with your risk profile.

How do you get started with diversification?

Getting started with diversification is actually much easier today than it was even a decade or two ago, especially for those who feel they don’t have time for the research that needs to be done to get diversification right.

One option is to use an exchange-traded fund (ETF), which is essentially a grouping of securities that can be bought and sold as a group, is managed by a brokerage firm, and is allocated to blend across asset classes based on different criteria or commodity types. For a fee, you pass on the cost of the research and management to a professional firm in exchange for the potential long-term gains within the portfolio. ETFs can be bought with your own money market accounts, an individual retirement account (IRA), and often through your employer-sponsored 401(k) retirement plan.

Another option for those who want a more personalized experience designed around their values, goals, and place in their financial journey is to meet with a personal financial advisor who can help you find the right investments, risk profiles, and options to fit your needs.

Whether you’re an experienced investor or just starting out, diversification is a critical part of protecting your investment and maximizing your potential gains. However, that sweet spot where you accept the right amount of risk given where you are in your financial journey is not only hard to find, but it also changes over time as market forces shift and as you near retirement. 

If you are wondering how to get started with diversifying your portfolio to align with where you are in your life, your values, and your goals—or even if your current portfolio is diversified enough—the experienced team at Harvest Wealth Group would love the chance to meet with you and help you on your financial journey. 

Click here to schedule your own personalized consultation. Also, check out another blog article that may be of interest: “How a Personal Financial Plan Helps You Reach Your Financial and Life Goals.”