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What Is Diversification?

Chime Team • July 11, 2024

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Diversification

Diversification is an investment strategy that spreads risk across various types of investments within a portfolio. The idea is straightforward: By not putting all your financial eggs in one basket, you minimize the risk of a significant loss.

Investing in a mix of assets – like stocks, bonds, and real estate – can help reduce the impact of poor performance in any single investment.

Diversification is a foundational principle of personal finance and investing, allowing people to protect themselves against market volatility and economic downturns. So, when one asset class underperforms, another might outperform, balancing the portfolio’s overall performance and potentially yielding steadier returns over time.

One way to see diversification in action is through mutual funds or exchange-traded funds (ETFs), which inherently include a diverse range of assets within a single investment vehicle. These funds allow investors to achieve diversification more easily and with less capital than purchasing individual stocks or bonds directly.

According to some calculations, a diversified portfolio consisting of 60% stocks and 40% bonds has historically provided a balanced mix of risk and return, yielding an average annual return of about 8.8% from January 1, 1926, through December 31, 2021.¹

Diversification, personal finance, and the broader economy

Diversification is crucial in personal finance because it directly relates to a person’s risk tolerance and financial goals. By diversifying their investments, investors can tailor their investment strategies to achieve specific financial objectives while managing the level of risk they are comfortable with.

For instance, younger or beginner investors might opt for a higher proportion of stocks for growth, while those nearing retirement might prefer savings bonds for stability.

The concept also plays a significant role in the broader economy. Diversification across industries and sectors can help stabilize financial markets by reducing the potential for systemic risks. When investors spread their investments across various sectors, the economy is less likely to experience severe downturns due to the collapse of a single industry.

Diversification strategies

Diversification involves spreading risk across various sectors, companies, asset classes, borders, and time frames.² Within sectors, investing in different industries, like automobile and airline manufacturing, can help protect against industry-specific downturns.

Company-specific risks – like the impact of an executive leaving a company – can be mitigated by holding shares in multiple companies within the same industry. Diversifying across asset classes – like stocks, bonds, real estate, and alternative investments – ensures that not all investments are affected by the same economic conditions.

International diversification helps protect against domestic policy changes by spreading investments across different geopolitical climates. Additionally, balancing investments across various time frames, from short-term bonds to long-term real estate, can help manage liquidity needs and optimize returns over time.

By employing these strategies, investors can create a resilient portfolio capable of weathering various economic conditions.

Diversify for peace of mind

Diversification is a critical concept in investing and personal finance. It offers a strategic approach to managing risk and pursuing steady long-term returns. While diversification can reduce the risk of significant losses, it does not guarantee profits or protect against all risks.

Interest rate changes can impact bond values,³ while inflation erodes real returns, though assets like real estate may hedge against it. Government and central bank policies can shift economic trends, influencing investment outcomes.

Understanding and applying diversification principles can help investors make more informed decisions about their investments and financial planning, ultimately leading to more secure and prosperous financial futures.

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1 Information from Vanguard’s “Like the phoenix, the 60/40 portfolio will rise again” as of June 28, 2024: https://corporate.vanguard.com/content/corporatesite/us/en/corp/articles/like-phoenix-6040-portfolio-will-rise-again.html

2 Information from Forbes’ “How Diversification Works, And Why You Need It” as of June 28, 2024: https://www.forbes.com/advisor/investing/what-is-diversification/

3 Information from the SEC’s “Interest rate risk — When Interest rates Go up, Prices of Fixed-rate Bonds Fall” as of July 1, 2024: https://www.sec.gov/files/ib_interestraterisk.pdf

4 Information from Forbes’ “How Inflation Erodes The Value Of Your Money” as of July 1, 2024: https://www.forbes.com/advisor/investing/what-is-inflation/

5 Information from Forbes' "Why Income-Generating Real Estate Is The Best Hedge Against Inflation" as of July 1, 2024: https://www.forbes.com/sites/forbesbusinesscouncil/2022/04/14/why-income-generating-real-estate-is-the-best-hedge-against-inflation/

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