August 27, 2024
What we’ll cover:
Diversification is a word you hear often in investing.
It generally means: Don't put all your eggs in one basket. While that's a good starting point to understanding diversification, let's dig a little deeper.
Diversification is a strategy to help you manage your investment risks by spreading your money across a variety of investment vehicles and assets. The logic behind diversification is that by investing in a mix of assets (e.g., bonds, stocks and ETFs), your portfolio won’t be wiped out in the event that one investment (e.g., a particular asset or company) fails. That’s because, generally, different types of assets react differently to turbulences in the market.
Some assets are likely to perform better than others under certain market conditions. By diversifying, if one part of your portfolio isn’t doing so well, the other parts of your portfolio may be able to help cushion the volatility of the market.
Another important thing to keep in mind: The primary purpose of diversification isn’t to help you maximize your returns. It’s simply a strategy to help limit your exposure to certain investment risks. To be sure, while diversification has the potential to help improve your returns over time, it does not guarantee any return on investment.
Just as diversification doesn’t guarantee gains, it also doesn’t guarantee you against losses. Investing inherently comes with risks, and these risks can never be completely eliminated.
When it comes to investing, risk falls into two broad categories: systematic and unsystematic. Diversification can really only mitigate the latter.
Systematic risk affects the economy as a whole with impact on every company and sector. Causes of systematic risk are external, meaning they are generally out of a company’s control. Fluctuations to interest rates and exchange rates, political instability, and economic recessions are some examples of systematic risks. This type of risk is generally non-diversifiable. In other words, diversification can do little to help mitigate these broader economic risks.
Unsystematic risk, on the other hand, is company-specific or asset-specific. It is a diversifiable type of risk — the kind that investors can try to address via a diversification strategy. Company-specific risks may arise through poor business management decisions, financial problems, or legal challenges.
In short, diversification cannot eliminate all investment risks. While spreading your investments can help offset certain portfolio losses caused by company-specific risks, diversification is usually unhelpful when it comes to facing market-wide risks.
To build a diversified portfolio, you have the option to invest across asset classes, within an asset class, and across industries.
When investors look to diversify across asset classes, a few types of assets generally come to mind. These may include stocks, bonds, and short-term investments like money market mutual funds. A diversified portfolio typically contains a mixture of these investments.
You may also want to seek diversification within a particular asset class. For example, when you buy stocks, you probably don’t want to put all your money in the stocks of a single company. This is where mutual funds and exchange-traded funds (ETFs) can be helpful. These funds contain a variety of bonds and stocks, so that diversification is automatically built in. Take for example an S&P 500 index fund, which holds shares in some of the largest public companies in the US.
Investors who are interested in diversification may also look into adding sector funds, which focus their investments in a particular industry sector. For instance, there are mutual funds that invest exclusively in energy companies. But be careful not to concentrate too heavily in any one particular sector. Again, the goal of diversification is to minimize your exposure to certain company-specific (or in this case, industry-specific) risks.
It doesn’t have to be. Outside of the investment context, you may also apply the concept of diversification to your savings strategy. Although saving and investing are two different things, you can still think about diversification when it comes to managing your savings.
For instance, instead of simply stashing all your money in a single traditional savings account, you might want to consider spreading your savings among different types of savings accounts to take advantage of their respective benefits.
For example, a certificate of deposit or a high-yield savings account can typically help you earn a higher interest rate than a basic savings account.
Remember, saving and investing are both important aspects of your overall financial strategy. The idea of diversification may be applied to both.
Now that you know the basics to diversification, you might be wondering how much of your money should be allocated to which assets or how much diversification is enough.
Keep in mind that there's no one-size-fits-all diversification strategy. How you choose to diversify or allocate the assets in your portfolio depends on a number of factors, including your investment goals, time horizon, and risk tolerance. And just as your investment goals can change over time, so can your diversification strategy.
If you have questions or need help in building your portfolio, consider working with a financial advisor to discuss your goals and determine how to appropriately diversify your investments to achieve those goals.
This article is for informational purposes only and shall not constitute an offer, solicitation, or recommendation. This article was prepared by and approved by Marcus by Goldman Sachs® but is not a description of any of the products or services offered by and does not reflect the institutional opinions of The Goldman Sachs Group, Inc., Goldman Sachs Bank USA, or any of their affiliates, subsidiaries or divisions. Goldman Sachs Bank USA is not providing any financial, economic, legal, accounting, tax or other recommendation in this article and it is not a substitute for individualized professional advice. Information and opinions expressed in this article are as of the date of this material only and subject to change without notice. Information contained in this article does not constitute the provision of investment advice by Goldman Sachs Bank USA, or any of its affiliates, none of which are a fiduciary with respect to any person or plan by reason of providing the material or content herein. Neither Goldman Sachs Bank USA, nor any of its affiliates make any representations or warranties, express or implied, as to the accuracy or completeness of the statements or any information contained in this document and any liability therefore is expressly disclaimed.
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